WED 20 APR 2022
Three major fears in the market prevailing bias; 1) inflation; 2) higher interest rates; and 3) and an imminent earnings downgrade cycle are now widely appreciated consensus beliefs. They are also a plausible explanation for investment sentiment near the lowest level on record. The good news, following the brutal correction, is that the fixed income markets are now much better priced for the probable policy tightening cycle. The bad news is that the “real” 10 year yield (nominal less breakeven) has only just risen back to zero. Put another way, inflation risk compensation is still deeply unattractive.
The risk premium in equities is also mixed. Clearly there has been a material correction underneath the surface of the equity market. However, the global risk proxy (the S&P500) is only 7.2% below the record high and the rise in yields has compressed the difference between the earnings yield to the lower end of the historic range (chart 1).
To be fair, equities are a “real” asset and offer more compensation on an inflation adjusted basis. But the capacity of corporations to provide protection from rising prices depends on pricing power. In phases of much higher inflation (above 5%) equities tend to de-rate on the prospect of compression in profit margins and a higher discount rate. Historically, the “optional” level of inflation for equities has tended to be between 2-4%. That is, moderate enough not to impact earnings, but not high enough to induce a material increase in the discount rate.
While the key downside risks in the prevailing bias are well appreciated, we remain cautious on equities in the near term. Our major concern is deterioration in performance of assets that typically lead the cycle. In particular, the performance of US bank equities relative to the market has clearly diverged with the rise in Treasury yields (chart 2). As we highlighted last week, that observation is consistent with the performance of cyclicals more broadly relative to defensives, semiconductors, new orders relative to inventory in the ISM report, small business sentiment and the recent inversion of the yield curve (we do not take comfort in the subsequent steepening over the past two weeks). Clearly part of the challenging growth/inflation mix has been the ongoing war in Ukraine and (misguided) pursuit of COVID zero in China.
The good news in this region is that weak growth in China has led to a policy response. The credit impulse (rate of change in credit growth) has started to improve since the end of last year. Historically, that has contributed to the outperformance of MSCI China and regional equities over the following 12 months (chart 3). Moreover, the odds of outperformance have improved with MSCI China now trading at a trough multiple of around 10.5 times forward earnings. It is also important to note that the region also trades at a record 65% discount to the United States and offers an interesting mix of both secular growth and value.
In conclusion, the tactical challenge is that in spite of depressed investor sentiment, it is not obvious that the downside risk is fully priced into broader equities. As we noted last week, a long phase of artificial stability (through policy actions and promises) breeds explosive instability. Our sense is that markets are still pricing that risk. We would also continue to emphasize that a rising rate and liquidity withdrawal environment favours a bias to companies with strong cash flow and low balance sheet leverage. It is too early to take on stocks based on hopes and dreams of future growth.