February’s market volatility and subsequent drop in equities was triggered in part by rising yields for 10-year U.S. Treasurys.

“Whether equity markets like it or not, the 10-year yield seems to be on the way to 3% faster than expected,” says National Bank in a monthly equity report.

The question is, can the economy handle the large rise in yields or are equity markets potentially facing downward earnings revisions?

While the bank doesn’t expect a wave of revised downward earnings, it does expect “a period of consolidation as rising rates push investors to reassess fair value for a number of asset classes.”

Read: Why client coaching can’t be left for corrections

Earnings growth outlook for equities

As long-term interest rates rise, the biggest vulnerability for equity markets is valuation.

National Bank points out that price-to-earnings (P/E) expansion isn’t the norm at this late stage of the economic cycle, so for markets to move higher, “earnings will need to keep growing.”

Data indicate that earnings growth is likely.

For example, favourable financial conditions in the U.S., including tax cuts, have resulted in forward earnings estimates for the S&P 500 being revised upward recently (except for real estate).

“In the latest round of revisions, the consensus has raised its expectations for index earnings growth to 19.5% in 2018 followed by a robust 10.3% in 2019,” says National Bank.

In weekly commentary, Richard Turnill, BlackRock global chief investment strategist, indicates he’s overweight U.S. equities.

“Extraordinarily strong earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view,” says Turnill. “We like the momentum and value style factors, as well as financials and technology.” (He’s also overweight Japan and emerging markets, especially Asia, Brazil and India.)

However, for the S&P, the priced-in good news for earnings makes it more vulnerable to disappointment, says National Bank. A key risk factor is U.S. protectionism. “After all, the foreign share of S&P 500 sales is more than 40%,” says National Bank.

For the S&P/TSX, poor performance isn’t due to earnings. In fact, the index’s outlook is upbeat: “Earnings revisions have been the best since 2011,” says National Bank.

Read: Could the TSX rebound in 2018?

Rather, the index’s challenges are due to P/E compression in the face of NAFTA uncertainty and household debt.

“These concerns are clearly apparent in the performance of the Canadian dollar,” says National Bank. “It is the only major currency that has slipped against the USD in 2018 to date.”

Read: Near-term outlook for loonie and U.S. dollar

But the bank says current pessimism for the loonie and the S&P/TSX is overdone.

For example, the bank doesn’t expect NAFTA to be scrapped. “The best argument against NAFTA termination is the continued improvement of the U.S. labour market and the resulting U.S. labour shortages.”

What asset allocation looks like now

National Bank says its asset allocation is unchanged, with the bank continuing to prefer stocks over bonds.

Read: Fixes for fixed income as rates rise

“That said, it is important to remain on the watch for any unexpected pickup in inflationary pressure that would compromise the profit outlook by pushing the 10-year Treasury yield above the comfort zone of the economy,” says National Bank. “For the U.S. we peg the ceiling of that zone at around 3.5%.”

This month the bank has made a slight change in sector allocation.

“We are reducing our exposure to IT from overweight to market weight,” says the bank, referring to the sector’s outperformance in the past year. “We are putting our IT gains into golds, which we move from market weight to overweight.”

That’s because central banks are normalizing monetary policy at a measured pace, which implies a tolerance for inflation likely to benefit bullion.

“The price of gold will also gain from resurgent volatility if Washington opts to push more aggressively for trade barriers against non-NAFTA trading partners,” says National Bank.

For more details, read the full equity report from National Bank. And for details on Turnill’s asset class views, read the full BlackRock commentary.