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Market Vegetables

Asset allocation monthly – Disparate pricing

Daniel Morris

In this article:

    •  The market reaction to the Jackson Hole meeting of central bankers has been fairly sanguine: 10-year yields are a bit above where they were before the gathering and while equities have been weak, they have held on to a decent chunk of their gains since June. We took profits on half our sovereign duration short positions, closing our European short entirely, but sticking with a lighter US position.
    • The US Federal Reserve did not deliver the hoped-for policy ‘pivot’ and in referencing the need for a ‘sustained period’ of below-trend growth raised the bar for a turnaround. Service inflation — both wages and shelter — will be key to watch. It tends to be sticky.
    • Equity analyst forecasts for earnings meanwhile have remained much too high. This is not necessarily unusual, but it is striking given the concerns about growth. Revisions are rolling over though and adjusting for these, earnings expectations are negative. Europe is the clear weak spot, vulnerable to further downgrades and our main short position.
    • European investment-grade credit by contrast continues to look appealing at current valuations, as do commodities. 

    Attention deficit disorder

    The combination of the end of a 40+ year fixed income bull market, the transition from quantitative easing to quantitative tightening, pandemic fallout and the conflict in the Ukraine has led to the highest level of sustained fixed income and equity market volatility since the Global Financial Crisis (see Exhibit 1).

    This volatility has also been driven by distracted investors, whose focus has swung from inflation fears to growth worries depending on the latest data. Moreover, the focus of equity investors has frequently been the opposite of fixed income (inflation vs. growth).

    Government bonds saw sharp sell-offs late in August, encouraging us to raise European bonds from underweight to neutral on a risk-adjusted basis and close our short position. With sizeable moves in US bonds too, we took profits on the shorts we had built early in August, while remaining strategically cautious. Overall, our short government bond positions have now been broadly halved on the back of valuation-led moves.  

    We have upgraded Japanese government bonds to neutral, chiefly for technical reasons: we felt JGB shorts were at risk of a costly squeeze on the contract roll.

    Amid wider European investment-grade bond spreads, we built on the constructive positions we held. Spreads are now compensating investors for what we see as exaggerated default outcomes despite many IG rated companies boasting solid balance sheets and being long cash. Overall, our risk-taking has moved a bit lower, staying within the ‘dislike’ quintile as a result of these moves.

    As for European high-yield bonds, companies are generally (far) less protected from the deepening economic and energy-related woes, so we have neutralised our positive position versus euro aggregate bonds.

    Global equities rallied by 13% between the low in June and mid-August, with the US S&P 500 index up by 17%. This caused investors to wonder whether we were in a bear market rally, or if the moves could indeed have ‘legs’. Historically, the moves in the S&P have been around the median of around 20 bear market bounces since 1929.

    This leaves us cautious. Growth and earnings look unlikely to improve from here – Exhibit 3 shows the relative resilience already baked in. High inflation should ultimately eat into margins, particularly in Europe, while rising interest rates are increasing the cost of capital. Finally, forward equity valuations are lower now, but many are still at or above the 15-year median.

    Quant signals: Balanced

    Taking a closer look at quantitative equity market signals, the equity bottom-up element offsets fairly cautious messages from the other three pillars, particularly macro. Valuation and behaviour were more mixed across the regions.

    Variables captured by the ‘momentum’ category, such as operating income and revenues per share, are holding up (earnings per share have started to soften, but it is early days).

    The ‘quality’ component that reflects moves in return on equity, operating margins and net debt has also been relatively firm, although less so in Japan. Japanese valuations – and, to a lesser extent, behaviour – are offsetting the positives.

    Disparate pricing

    Moves in fixed income markets have been intense in recent weeks. At the time of writing, roughly half of the US yield curve is inverted. This is consistent with mounting recession risk – this is now at roughly twice the level it was at in the summer (see Exhibit 4). We are not quite at the 80% levels historically associated with recessions.

    Meanwhile, a super-simple measure of what equities are pricing based on their behaviour over the past 11 cycles has also increased recently.

    This disparate pricing likely reflects the distinct probabilities of how successful central banks and economies will be in traversing a narrow path of taming inflation without cratering growth. For the US, this involves: 

    • Slowing growth to below potential, allowing supply to catch up with demand
    • Rebalancing the labour market (and relatedly wages)
    • Stickier shelter inflation. 

    Success in each area so far appears mixed. As our economic research colleagues have emphasised, the question is whether US growth and consumption have slowed sufficiently, especially with fiscal tightening fading and financial conditions easing back. In the labour market, job openings are down by 600 000 since the peak. However, monthly payroll gains are still five times more than would be needed to stabilise unemployment.

    Three years of above-target inflation seem to be ‘baking’ into wages. Notwithstanding the inventory-led technical recession, the US labour market is, on many metrics, hotter than in boom times, presenting a clear challenge to the Fed’s dual mandate. With business inflation expectations sticky, and rental inflation high, the outlook for prices is now far from clear. It is notable that the interest rate expectations of the investment community more broadly have – unusually – lagged behind inflation expectations in recent months.

    Earnings outlook and valuations

    Equity markets have not been impervious to the deteriorating outlook, with US equities falling by more than 8% from the recent peak despite a mid-month rally. The declines, for now at least, seem to be driven primarily by the increase in the discount rate rather than falling earnings expectations. The recent moves are commensurate with what occurred in June, when expectations for the level of the fed funds rate in one year jumped by 100bp (see Exhibit 5).

    European equities, by contrast, appear to be reflecting nearer-term growth worries. While purchasing managers’ indices (PMIs) have remained robust in the US, several have dropped below 50 in Europe, indicating contraction. As the growth outlook worsens, markets are pricing in lower earnings (see Exhibit 6). It is worth recalling that during the oil shocks of the 1970s, the US Institute for Supply Management (ISM) manufacturing index fell to 30.

    Given the deterioration in growth we anticipate in both regions, determining the current level of valuations becomes more difficult. As noted, analysts’ earnings estimates are still quite sanguine about the outlook, but that inflates price-to-forward-earnings estimates. In this environment, looking at metrics such as price-book ratios may give a better assessment of the attractiveness of equity indices.

    In fact, Europe goes from looking inexpensive, at a nearly one standard deviation below the average forward P/E ratio, to having at best an average valuation. Japan is in fact similar, but we have more confidence in the validity of the earnings estimates there, meaning valuations are truly attractive. Emerging markets, notably, look compelling on both measures (see Exhibit 7).

    Asset class views


    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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