Global markets: Valuation ‘normalisation’ continues

The weak performance of global equities during 2022 to date is in our view primarily due to the ongoing normalisation of monetary policy in the US and Europe. Continuing to run loose monetary policy into a supply shock has manifested a highly challenging scenario of inflation well above target even as growth slows. Central banks did not appear to appreciate the full extent of the economic frictions in the global COVID-19 stop/start period of the past two years instead becoming over-focused on incentivising demand during lockdowns. Perhaps in hindsight it is increasingly likely that this period of ultra-loose monetary policy will become linked to a significant asset price bubble in the global technology sector.

Investors are also now grappling with the implications for food and energy prices of the war in Eastern Europe, a conflict of a nature not seen since the end of the Cold War. Furthermore, China’s zero-COVID policy has placed over 300 million people under lockdown restrictions in 2022, even as the rest of the world has learnt to live with the virus. The sheer transmissibility of Omicron suggests the economic risks of such a policy are mounting – and this may yet have further ramifications for global supply chains.

Movements in global sector indices are consistent with investors reappraising portfolio allocations and shifting objectives towards capital preservation in real terms, given an inflationary yet decelerating growth environment. This shift is clearly in evidence in relative sector performance in 2022 year-to-date. There continues to be a striking correlation between global sector performance and the overvaluation of that sector at the start of 2022, Exhibit 1.

Exhibit 1: Starting valuations strongly linked to relative sector performance in 2022, to date

The reason for this reappraisal by markets is two-fold in our view. First, investors are slowly realising the US central bank is serious about bringing inflation under control. We believe the US Federal Reserve (the Fed) remains confident it has the mandate to act aggressively on interest rates with the economy still strong and inflation approximately three times the 2% Fed target. As a result, interest rate markets are discounting one of the most rapid rates of US monetary tightening seen over the past 30 years. The volatility in interest rate expectations has flowed into FX markets, where the Japanese yen has depreciated by 14% in only six weeks. China’s yuan has also fallen by over 6% in the same period.

Second, the global economy is losing momentum. Purchasing managers’ survey data show that manufacturing output is declining. We believe the reasons for this decline are multi-faceted but would highlight any one of a large inflation shock, energy shock, fiscal shock or monetary shock would individually have the capacity to induce a major slowdown.

In 2022, investors are having to contend with all four factors, at once. We therefore believe it is uncontroversial to suggest the risk of a recession is mounting as COVID-19 related fiscal stimulus is being withdrawn while food and energy costs are eroding consumer confidence and crimping discretionary spending. In Germany, the key ifo institute survey is now at levels not seen outside the initial COVID-19 downturn or financial crisis of 2008, Exhibit 2.

Exhibit 2: Germany’s ifo institute survey highlights recession risks

However, we also believe the extent of the market moves in both equity and government bond markets have been amplified by investor complacency and ‘reaching for yield’ – or growth at any price – during the last two years, at a time when monetary policy was loose and the prospect of inflation appeared remote.

The performance of equities has been sufficiently poor to push many of Europe’s national stock exchanges below their long-term average price/book multiple even if US equities remain expensive on this measure, Exhibit 3.

We have written previously about longer-term inflation pressure both from demographic change and deterioration of trade relations between China and the US. However, these are dynamics likely to act over a relatively long-term horizon; for the short-run we believe the pricing power of labour is not as strong as during the highly unionised periods of the 1970s. In our view structural trends should not be overstated as the business cycle turns.

Furthermore, given the sheer amount of global debt of $226trn or 256% of world GDP according to the IMF, we believe central banks should be easily able to cool demand, even if inducing temporary recessions proves a necessary price. For example, the Bank of England has effectively officially sanctioned this as policy by both raising interest rates and forecasting a lower level of UK GDP at its most recent policy meeting.

Rather than the current narrative of an inflation crisis, the balance of probabilities in our view is towards a period of a relatively weaker jobs market and slower growth in both the US and Europe over coming quarters. Compared to the increasing probability of an ‘ordinary’ recession, inflation is comparatively relatively less likely to continue to escalate, although we acknowledge that inflation uncertainty is unusually high.

We therefore view US long-term bond yields are becoming increasing attractive at yields above 3%. Provided inflation can be returned to levels close to 2%, real yields are unlikely to stabilise at levels significantly above 1%, given current trends of productivity and working age population growth. Long-term government bond yields have risen very rapidly on any historical basis and while we would not wish to call a precise top in yields at this point, we believe rates above 3% in the US represent a bet on the Fed not being able to achieve its inflation goal.

It may yet prove to be the case that at current yields, high-quality government bonds may finally start to provide diversification to portfolios after an unusual period of declining in tandem with equities during 2022 to date.

For equities, following the recent market declines, the valuation picture for global markets is significantly improved since the 2021 year-end. Outside the US, many markets are trading in-line with their long-term price/book averages even if the global technology sector itself still has some way to fall to reach its long-term average. In addition, earnings forecasts for 2022 remain stable for now. While there may be some pressure on estimates in coming quarters as the economy slows as we expect, it is too pessimistic to suggest at this stage that a collapse in corporate profits guidance is underway, as happened at the onset of COVID-19.

Exhibit 3: Global equity valuation picture improving following market declines

We therefore maintain a neutral outlook on global equities at this stage, as much of the froth has been blown away from the valuation excesses of the post COVID-19 recovery period. Investors should in our view start to look for opportunities thrown up by the market turmoil where valuations are below long-term averages. While the probability of an economic contraction is rising this should not deter investors where valuations are already discounting this outcome. We believe positive catalysts for the market include reduced Russian military activity in the south and east of Ukraine, in addition to any potential softening of China’s zero-COVID strategy.