House View: April 2022

April 28, 2022

With the first quarter of 2022 now behind us, and more than a month of military activity in central Europe of a scale unseen for 70+ years, an assessment of the potential political and economic fallout is necessary. Assumptions that were held early this year must be critically re-examined. Today, the spectrum of outcomes is exceptionally broad, so we think it important to share our current views and hypotheses as to what the next months might bring for investors.

The initial shock at the developments in Ukraine is still being felt by many, but the first consequences for the real economy are also underway. Eurozone March inflation estimates point to a 7.5% year-on-year rate, which is some 70% higher than the previous peak in the summer of 2008, right before major turmoil in global markets. Also in the US, price pressures are significant, with the core CPI inflation rate at more than double the previous 25 years’ peak, at 6.4%. The extent of inflation rate overshooting is already astounding and one part of this is an ever-scarcer situation for many commodities, leading to colossal price rises for instance at the gas pump.

Soft landing or the r-word?

It appears that central bankers are waking up hard to this new reality, having projected a much more benign path for prices in the economy as recently as six months ago. There is now much more hawkish language and also a distinctly tighter monetary policy bias signaled for the coming months. Federal funds futures in the past 6 months have moved by more than during the Fed’s past hiking cycle between mid-2016 and end-2018, strong evidence of the structural change towards a new monetary policy environment that is happening.

Futures-implied Fed Funds Rate 18 Months Out

Startled central bankers

Will the supply shock in oil and commodities in general push the Western economies into recession, as happened several times in the post-WW2 era? Or can the accumulated savings of the past years help consumers stomach a steeply higher energy and food bills, next to other significant price jumps for many products in daily life? We consider the challenge for central bankers in the coming quarters to be most formidable, as a protracted bout of high inflation rates could put further pressure on the labor market. Labor supply will be asking for considerable pay rises, with the unemployment rate within less than half a percentage point of the all-time lows and a still a record amount of job openings.

Markets are reacting to the sudden and chilly up-move in yields going forward, and it is not a positive sign that corporate bond spreads are embarking on a widening trend after having touched a two-decade low in mid-2021. Liquidity is being drained and that usually weighs on market prices, as experienced in the final quarter of 2018. The Fed’s bloated balance sheet is about to be reduced, as many economists agree, but there is a wide range in terms of the pace of the reduction expected.

Marred consumer confidence

Consumer confidence, both in the US and in Europe, has sagged in the face of risen uncertainty and an acceleration of prices. The prospect of a newly drawn iron curtain, with far reaching consequences for global trade, is frightening many. Risk markets are discounting the current uncertainty and the growing headwinds from a tightening monetary policy so far with some ease, it appears, considering the strong bounce from the lows recorded in equity prices by mid-March in the order of up to 10%.

US & Eurozone Consumer Confidence

We would however remain very cautious, as equity prices remain vulnerable to a potential revaluation in the face of more difficult earnings prospects. Furthermore, the increasing likelihood that a recession, be it short and on the shallow side, could visit Western economies before year-end, does not raise our prospects for equities in the coming months. There are already discussions as to when the Fed may have to come to the rescue and support markets with renewed liquidity due to stock market losses: will they act at -20%? At -30% from the highs, i.e. at around 3400 points? Time will tell.

Turning point

There is however a major swing underway – much investment capital parked in low yielding bonds (with USD 65 trillion worth of bonds reflected in the Bloomberg Barclays Global Aggregate Index on average yielding to maturity a mere 2.15% as of early April), is looking to invest elsewhere. The global equity dividend yield currently lies just below 2%, for comparison. The elephant in the room is what will happen if inflation proves to be a lot stickier than previously assumed by central bankers: will they fight inflation with a ruthless series of 50 basis point hikes until the beast lays slain (and the economy suffers from a deep recession as a result of the monetary shock)? If this outlook of an uber-hawkish Fed is to become reality in the coming months, we strongly doubt a positive performance for equity markets (and to a certain extent also for bond markets).

Global Bond vs Global Dividend Yield

Soaring commodity prices

The Russian invasion in Ukraine has strongly added to commodity price pressure, with about half of the 25% price move since the end of 2021 having taken place after the war began on February 24, 2022. As any end to the hostilities is not to be expected any time soon, the pressures will remain high and with some commodities likely even to get worse, should we experience a protracted conflict. Therefore, the inflation picture will for many months look bleak.

How bond yields will behave in such an environment is the million-dollar question. We have already witnessed a steep upmove in government bond yields, e.g. in the 7-year Treasury by more than 100 basis points since the beginning of the year, with a 80 basis points move in March alone. The slope of the yield curve has also changed in some term areas, signaling danger ahead. Comparing the yield on 10-year Treasury bonds with the federal funds rate implied by the futures market 12 months out, trouble seems set to come, as 10-year yields are about half a percentage point lower than today’s expectation of the leading (short-term) interest rates 12 months out.

US Nominal GDP Growth Minus 5-year Treasury Yield

What about those equity earnings?

Stock valuations in historic comparisons are still elevated in the US, driven in part by a dominant tech sector with strong pricing power and immense scalability in their business models. In recent time, however, a formidable array of headwinds for the “growth” sector has entered the scene, ranging from potentially heavy regulation by governments with a possible revival of the antitrust mood of the early twentieth century, over to heated up competition reducing margins up to a bulky increase in discount rates, leading to lower net-present-value-based valuations. Longer-term earnings estimates, such as the aggregated index earnings three years out, reflect a degree of optimism that is hard to justify, in our view.

S&P 500 Earnings Estimates Three Years Out

Analyst estimates usually lag

A first glance at the earnings picture can be taken in the coming weeks, as the Q1 earnings season is about to start. Rising input costs could take their toll on the projected margin increases, and guidance is likely to be toned down, considering all the uncertainty, still existing bottlenecks as well as an increasing shortage on the labor market. Will earnings estimates therefore continue to rise? We would object, as analyst earnings estimates very often follow market drawdowns, with a lag of 1-3 months. In the past 20 years, there have been four instances in which (for the current fiscal year) estimated earnings for the next fiscal year dropped by more than 12%: 2002/03, 2008/09, 2015/16 and 2019/20. In each of these instances except for the period of the global financial crisis, a significant stock market drop triggered cuts to earnings estimates that continued for 3 or 4 months. During this time, that is from the equity market low until the low in earnings estimates, the stock market had already recovered a significant part from the plunge.

In the case of 2008/09, the stock market peak (October 2007) was 9 months ahead of the peak in earnings estimates, i.e. equities already turned south while earnings were being estimated to grow for another 9 months. Translated into 2022, that would indicate that somewhen towards the end of the coming summer (9 months after the stock market peak in December of 2021), the peak in earnings estimates will be reached and they will start heading south as well – likely as the result of a weakening economic outlook, paired with a more and more hawkish fed. In short: The outlook for equity prices for the remainder of this year and possibly beyond remains difficult.

Major Equity Markets’ Forward P/E

High P/E dispersion across markets

Valuations of different major equity markets on a forward P/E basis are displaying the highest dispersion in 10 years. On top lies the US equity market, with a big premium to the global average, while Eurozone equities are cheaper by about a third, with EM and UK equities offering a 40% and 45% discount, respectively. Time for a major turn after a decade-old relative uptrend of US equities relative to the global equity market appears fundamentally well-founded, therefore, and even more so if a continued rise in bond yields continues to chip at the mega-cap names in the tech sector. The current combined value of more than USD 7tn for the top 6 of them may also be seen as a scaringly high point from which to fall…

Regime change

We have left an environment in which inflation is sought after and a generally positive sign of healthy economic growth for one in which inflation fears are triggered by further commodity price rises, weighing on equity valuations. As a consequence, what is good for rising commodity prices is bad for equity prices, and hence the positive correlation between the returns of the two asset classes turns negative. Parallels to the early to mid-1970s are growing, and the recent oil price surge due to the war in Eastern Europe is eerily reminiscent of the oil shock in 1973, when OPEC imposed an oil embargo on the US.

Global Equity/Commodity 52-Week Correlation

An increasingly negative correlation between commodities and equities by definition increases the portfolio diversification benefits of combining the two asset classes, therefore we expect strongly growing investment demand for the commodities sector in general for the coming years. Added to already tight supply-demand balances, this demand factor could lead to temporary price spikes in several commodities essential to real economic growth such as energy, industrial metals, metallurgical coal, or agricultural products such as grain. Such a scenario’s significant repercussions for gdp growth should not be underestimated.

Not all is expensive

The big valuation dispersion, both on a regional and an industry-specific dimension, may also be considered a good thing – as there are to be found attractively-valued national stock markets with a good position in key industries, such as the South Korean one with its global player in the chip industry and a currency with revaluation potential. On the sector side, we like health care, and in particular biotech, with its price-to-cash-flow ratio one standard deviation on the cheap side relative to the market, based on the past 20 years of data. Whether now is the time to deploy all of the dry powder, we sincerely doubt. However, we advise preparing oneself to add into strong bouts of weakness, at a time when buying feels like a terrible mistake considering the dropping prices. As one famous Wall Street saying goes: Buying right never feels right. We expect 2022 to offer several opportunities to practice such an approach.

Fiat currencies and digital assets

On forex markets, the trend of 2022 was clearly that of a strengthening dollar, with the horrors of large-scale war in Central Europe adding to the greenback’s appeal. Europe’s geographical and hence economic proximity to its two largest countries has made it more vulnerable, while a flight to the safe haven of the US dollar in a geopolitical crisis of very high degree appears natural. The Fed’s latest signals in terms of raising rates much more aggressively than previously communicated has added to the yield advantage the US currency, further bolstering it against others. However, we are not convinced of a continuation of the past 12 months’ 10% up-move due to structural factors such as the chronic current account deficit and a potential re-allocation of global investors out of the US. The latter with its enormous proportions in our view could move the dollar down massively, especially if the political will to rein in the budget deficits continues to be absent. Some selling into strength should provide very good risk-reward, we feel.

Bitcoin 20-Day Historical Volatility

Digital assets in 2022 have had a rather dull period, with maximum swings for bitcoin limited below 40% in the first quarter, the lowest since 2019. 40% swings in other asset classes would be considered meltdown, but not in digital assets. Compared to previous “crypto winters” after strong run-ups that cumulatively reached -85%, the current colder season does not match. There are quite a few differences to the period of four years ago (bitcoin’s halving, i.e. cutting the mining revenues by half every four years defines the cycle), among them a completely different path of (realized) bitcoin volatility, which has gone sideways for more than a year now, compared to a continuous downtrend from very high levels in throughout November 2018, when volatility soared again on the back of another plunge in bitcoin prices.

A continued phase of backing and filling appears quite likely. New highs appear not too likely, as a catalyst is lacking, in our view. However, further bouts of weakness will be used by many underinvested market participants to add, a notion that we would support for those without any exposure to this emerging asset class, as our long-term view remains very positive.

Conclusion

► Despite the strong bounce off the lows since mid-March, we see a clouded outlook for equities in the coming months.

► The repercussions of the events in Eastern Europe added to already tight supply on the commodities market and prices continue to surprise to the upside. Wage data in the coming months will be followed very closely by market participants, as the risks of a beginning wage-price spiral are material.

► Major central banks, and especially the Fed, have woken up from their “transitory inflation” lull, and markets have re-priced interest rates at an alarming pace, distantly rising memories to spring/summer of 1987.

► We would not underestimate the risks stemming from a continuation of the steep rise in rates, that could evoke financial stability concerns, which then by feeding on themselves could lead to some form of panic.

► It will be interesting to track consensus earnings estimates over the coming weeks and months, as history would suggest that a drop is imminent, leading to a further headwind for equities.

► A cautious strategy therefore should help weather the turbulent environment that has started, and we suggest keeping dry powder to add exposure into weakness going forward.

► Digital assets could see further weakness near-term that can be used to add to this emerging asset class as well.

DISCLAIMER: This document is intended for marketing purposes.

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