As at 28 June 2023
Author: Gavyn Davies, Chairman
Main Points:
- Equity markets have dipped slightly in recent days, but only after surging in mid-June above any levels seen since the major bear phase took hold in 2022.
- Equities in the advanced economies are up 13% year-to-date1, led by Japan (26%)2 and the Nasdaq (27%).
- These changes have been partly triggered by economic fundamentals, including supply-side gains in commodity markets, AI, labour markets and supply chains. These supply-side gains currently show no signs of reversing.
- Aggregate demand still seems adequate to support these supply gains for now, but activity growth in the AEs has slipped below trend and needs careful watching.
- Central banks are moderately hawkish, so a clash between slowing economies and tighter monetary policy could threaten the equity rally. Given plummeting activity data and weak nowcasts in the EU, this clash seems much more likely in the European markets than in the US or Japan.
- Overall, economic conditions seem less favourable for equity gains than they were in the first half of 2023, but a renewed bear market is not yet signaled.
In a previous edition of Chairman’s Views, we argued that equity markets in the advanced economies were continuing to defy the general mood of pessimism among many analysts because several powerful economic forces have been at work, making a soft landing appear more probable to investors than the consensus believed at the end of 2022. The sharp rally continued until the hawkish FOMC meeting on 14 June, but since then the S&P 500 has dropped by about 2%, and the sustainability of this year’s rally is now a key issue facing global investors. What is going on?
Source: Fulcrum Asset Management LLP & Bloomberg
It is difficult to attribute the 2023 equity rally to “value”, or value-related trades. Although it is true that the sell-off last year had left the US equity market 6.3%³ below the 12-month moving average at the end of 2022, oversold markets do not necessarily represent compelling “value”. There are many ways of measuring the “value” of equities relative to company earnings, dividends, and bond yields (real or nominal). The leading metrics in common use in the financial markets suggested that US equities, at the end of last year, were trading somewhere in a range between “fairly valued” and “sharply overvalued”:
- The PE ratio for the S&P 500 was 19.5 at end 2022, compared to a trailing 10-year average of 20.2.
- The Shiller CAPE ratio was 28.3, compared to a 10-year average of 26.5.
- The dividend yield4 was 1.7% compared to a 10-year bond yield of 3.6%, so the yield gap was 1.9%, compared to a decade-long average of 0.3%. Wider yield gaps indicate less attractive valuation for equities relative to bonds.
- The Fulcrum Macro Allocation and Risk System (MARS) asset allocation model at end 2022 predicted a one-year excess return from equities (above cash) of 4.9% per annum, compared to an historical average excess return of 5.5%. This expected one-year excess equity risk premium – our preferred measure of “value” in the asset allocation model – was close to the bottom of the long run historical range for equities, which the model estimates to be 4.8-6.2%. An ERP of 4.9% clearly represented sharply overvalued territory5.
We therefore do not believe that the equity bounce this year has been driven by the elimination of exceptionally compelling “value” in the overall market indices at the start of the year. Instead, valuations have moved into expensive territory. According to David Kostin of Goldman Sachs, the next-twelve-months (NTM) price-to-earnings ratio was 16.8 at the end of 2022 and this has risen to 19.1 now. The increase of 13.6% in this measure of valuation almost exactly accounts for the rise in the market, leaving no significant role for any rise in the central expectation for earnings themselves. Kostin estimates that this has left the current valuation of the market (using 6 different metrics) standing at around 1.1 standard deviations more expensive than the ten-year historical average. At the end of 2022, this composite measure was exactly at zero.
The performance of different sectors and styles within the market shows clearly that this has been a period in which “value” has underperformed as a driver of returns. For example, returns on the Nasdaq have been approximately double those on the entire US market. The Sharpe Ratio on growth stocks (ie returns per unit of risk) was 2.3, compared to 0.3 for value stocks. Growth sectors have outperformed value sectors, even though the P/E of value stocks versus growth stocks in the market has been close to historic lows. After the stronger performance of value stocks in 2022, many stock pickers are no doubt frustrated by this failure to follow through.
The interpretation of these patterns of behaviour in the overall market and different sectors can be debated. We believe that two main factors may have been responsible:
- The first is the emergence of AI as the prime source of extremely strong optimism about future profits growth to be found anywhere in the market. Although this would not show up in the NTM earnings estimates, it could have shifted the distribution of expected earnings in the very long term to the right, possibly with a fatter right tail than normal.
- The second is that the main advanced economies have shifted away from fears of a hard landing. Headline inflation has fallen sharply, reducing the probability that the central banks would need to respond with extremely hawkish monetary policy, causing a deep recession later. Obviously, rising hopes of a soft landing or no landing scenario should prove favourable to equity returns, especially in growth sectors, and so it has proved.
The Fulcrum “economic shocks” model estimates the source of major shifts in the US equity market, derived from the combined behaviour of all major financial asset prices over the same period. It can therefore help us to quantify the sources of high equity returns more precisely. The following graph shows the period of powerful gains in in the market that started in late March.6
Source: Fulcrum Asset Management LLP & Bloomberg
Since the SVB crash in mid-March, the combined shocks have resulted in a rise in the S&P index of about 10%, even though conventional monetary policy has tightened slightly. A little over half of the overall gain has stemmed from three major shocks: lower oil prices (black zone); improved supply-side gains (amber); and improved risk appetite (red). Most of the remainder has come from the residual (grey). As noted above, this residual can probably be attributed to increased optimism about the long-term benefits to profits in the AI sector, though we do not have firm evidence for this view.
The combination of supply-side improvements, adequate growth in nominal demand and modestly hawkish central banks has been very beneficial for risk sentiment in the first half of 2023. The segment of this package that seems at most risk of deteriorating markedly is the growth of demand. We are continuing to monitor this very actively. In the recent past, the main sign of weakening has been the decline in the PMIs in the EU in June. The European economy is already on the brink of slipping into significantly negative territory, to judge from the GDP figures in 2022 Q4 and 2023 Q1. The Fulcrum nowcasts are also indicating increased downside momentum, with recession risks in the nowcast models now placed at a very high 55%. It will be critical to watch for any indications that the labour market is beginning to crack, but this has not happened yet.
Source: Fulcrum Asset Management LLP & Bloomberg
Conclusion
The first half of 2023 has been marked by improving supply-side factors in the global economy, most notably in the form of declining oil and energy prices. These changes have been accompanied by solid growth in aggregate demand. Manufacturing sectors have been weak, but this downside risk – which is clearly rising in the EU – has not been powerful enough to offset the strength in service sectors and in the labour markets. Central banks have responded to sticky core inflation by tightening monetary policy but have refrained from the massive hawkish shocks that dominated markets last year. In fact, despite increases in short-term policy rates, financial conditions indicators have eased lately, at least in the US. The credit shock in the US regional bank sector has not yet tightened credit supply very much but has reduced expected policy rates in the forward curve, which has (perversely) supported risk assets.
From now on, it is possible that the lagged effects of previous monetary tightening and the credit shock may begin to dampen aggregate demand, in which case there may be further signs that the labour markets are cooling. This could be the signal for a negative demand shock, which would probably produce some downside for equity markets. This seems far more likely to happen in the EU and UK than in the US or Japan, based on current information.
As always, a great deal will depend on the behaviour of the oil price, which is almost as important as growth and monetary policy shocks for asset prices. Amid considerable uncertainty, Fulcrum’s view is that the expected deficit in oil supply relative to demand has probably been postponed until next year, in which case the risk of a severe hard landing in the US will remain no greater than moderate.
