Summer blooms or temporary displays?
The mood is temporarily better in markets. Will it persist, or will it be like the show gardens of SW1 at the RHS Chelsea Flower Show – here today and gone tomorrow? If global macro trends don’t worsen over the summer, return prospects should improve for the second half of the year. I’ve already said I think the worst is over for bond markets but picking the bottom in equities is trickier. Focus on earnings and valuations. Some sectors have seen big downward revisions to both. There might be found the opportunities for a sunnier outlook for investors.
As a resident of London it is always wonderful to see the streets in bloom this time of year in celebration of the Royal Horticultural Society’s Chelsea Flower Show. This is the first time since 2019 it is being held at its traditional time of year with no social distancing and no requirement to wear face masks. What a sign of being back to normality, at least in the UK. The mood is somewhat reflected in the markets too. The last week or so has seen positive returns across bonds and equities. Bond yields have continued to move lower, credit spreads have narrowed, emerging market bond indices are higher and the S&P500 is up and back above 4,000. But the flower show only lasts for a week and the question is, are markets just showing us a little bit of growth and colour before they wilt again?
No “new” news
The spring recovery could just be a little bear market squeeze, particularly when one considers the number of public holidays this time a year, which is truncating trading sessions and leading to a worsening of already challenging liquidity conditions. Yet there is also more talk of turning points and markets bottoming out. There is no “new” bad news and investors have got used to the energy crisis, the war, Fed and ECB tightening and the prospect of slower growth going into 2023. “Big thinkers” are talking about regime change and the economics of scarcity, but I get the sense that none of that is going to show up in anything different to what is already framing expectations, at least in the short-term. The reality is that investors have cash and, at some point, will put it to work.
For some time, the bullish narrative has been around inflation and interest rate expectations peaking in Q2. Certainly, expectations of how much the US Federal Reserve (Fed) will increase the Fed Funds rate have eased back, with the terminal rate for the cycle settling in between 2.75% and 3.00% by this time next year. Longer-term yields have also come off their highs with the benchmark Treasury 10-year yield now at 2.75% relative to an early May peak of 3.20%. Break-even inflation spreads are also lower and in the credit markets risk premiums have eased back over the last week. My call from two weeks ago that now was not the time to sell and could even be the time to buy fixed income is working out well so far.
Business cycle investing
Markets adjusted more abruptly at the outbreak of the COVID pandemic. But back then we were really entering the unknown and the global economy essentially shut down. Today the challenges are more traditional business cycle concerns. Strong growth, fuelled by policy stimulus in 2020-21 has pushed inflation higher and led to higher interest rates. Policy stimulus is being withdrawn (slowly) and higher living costs are squeezing consumer incomes. Tighter financial conditions will impact on marginal credit growth. All of this means lower GDP growth rates and the potential creation of some capacity in developed economies in order to help bring inflation back down.
Economists will argue (they do don’t they) about the magnitude of all of this but investors have to assess where capital will best be rewarded in an environment which is likely to impact on corporate revenues and margins and where consumer spending, which boomed during the pandemic as well all bought stuff online, eases back. It is much trickier to take the view that it is time to get back into equities just now. Just recently, several large scale retailers in the US have spoken of having excess inventories which is going to lead to price discounting. Where there are shortages of some things, it appears there is oversupply of other things.
Real rates and equities
We have been looking at the relationship between equity valuations and real interest rates (thanks to my colleague Jonathan White in the Equity QI team at AXA Investment Managers). De-rating has been going on for some time and has been most extreme in the “growth” areas of the equity markets. Generally, price-earnings ratios at the market level have fallen by around six percentage points over the last year and a half. That has coincided with a rise in real interest rates, with the bulk of the moves on both p-e ratios and real rates coming over the last six months. If real yields, and nominal yields, have cyclically peaked then there is less reason for more de-rating, in general, in equity markets.
US still expensive relative
However, the devil is still in the details. The US broad market (S&P500) still has a valuation premium to other developed equity markets. That reflects the superior growth performance (historically and expected) of US equities and, it has to be said, that the differential between the US and the rest of the world has come down a little. Taking the current price-earnings ratio based on 12-month expected forward earnings, the US is still five percentage points higher than an average of European and Asian markets. This is back to where it was at the onset of COVID.
Cheaper consumer stocks
Rising yields have also been associated with outperformance of value relative to growth. Maybe this has also run its course. The gap between the price-to-earnings (p-e)ratios for the S&P growth and value indices has narrowed and it is close to the level that predominated before COVID. There have also been huge sector differentials. In the US the sector that has seen the biggest downgrade to 12-month growth forecasts and the biggest de-rating in terms of the 12-month price-earnings ratio (year-to-date) has been consumer discretionary. This of course clearly reflects the impact of higher inflation on real household incomes. Information Technology has been de-rated significantly, but so far earnings forecasts have held in. On the other side of the coin, earnings forecasts have been revised up and p-e ratios fallen the least for financials, energy and materials. Macro-economic trends have played out in intra-market performance.
Lots priced in for some sectors
I think there are arguments for being more positive on growth now. There has been de-rating and there has been downward revisions to earnings expectations. Arguably the performance of value has been largely attributed to energy and financials. If energy prices are peaking then there might be enough already priced in – the current I/B/E/S consensus for S&P500 energy sector earnings growth over the next year is 36%. Given market moves and slower growth, the outlook for financials is probably a little tarnished as well, compared to the last two years of low rates, plentiful liquidity and higher asset valuations.
Of course, it all depends on earnings now. The current consensus is that earnings will continue to grow over the next year. The risk is that these forecasts turn negative as more and more companies see revenue growth challenged and margins compressed. So quality is going to be important in equity portfolios. The same can be said in credit. Higher yields provide the cover to move up the ratings scale. BB-rated high yield bonds in the US yield almost the same today as CCC-rated bonds yielded a year ago and what single B-rated bonds did back in February of this year.
Still, stocks are not screamingly cheap yet
Strategies that focus on better quality in terms of low default risk in bonds and stable (above market) earnings growth in equities should be the ones that succeed over the next 6-12 months. The risk is that global growth worsens by more than is currently in the forecast as a result of higher rates, squeezed real incomes and deteriorating confidence. Another 10-15% leg down in equity markets can’t be ruled out and the read across to fixed income would be (lower yields) wider credit spreads. The nagging thought is that the reduction in valuations in the US equity market (in particular) has only brought p-e ratios back to just above the average for the last twenty years. Europe, emerging markets (in aggregate) and China are all about on the average while the UK and Japan are just on the cheap side. If bond yields stay at 2.75% in the US and earnings forecasts remain stable, there is still another 5-10% downside for the S&P on my equity risk premium metric.
Diversified exposure to growth with a hedge
I guess where I land with all of this is a more positive view on bonds, a more neutral view on equities with a focus on growth for the recovery when it comes. A portfolio that has a bucket of long duration assets, high yield credit exposure (short-dated bonds), and growth and quality oriented equities would be my preference for the second half of the year. As always, it depends on the data and policy decisions, but valuations are cheaper than at any time over the last year.
23 years ago this week Manchester United completed the treble of being FA Cup, Premier League and Champions League winners. No-one has matched that since. United are a long way off repeating it too and most fans are so glad this season is over. Later in the summer I will review the prospects for next season under the leadership of our new manager, Erik Ten Hag, but for now, go Karim!
Subscribe to the weekly CIO viewsSUBSCRIBE NOW