Key global market moves – war and rates hurt sentiment
Global equity prices weakened a further 1.1% in February after a sharp 6.2% decline in January, as persistent global interest rate and inflation worries were joined by a new risk factor – Russia’s assault on Ukraine – that further undermined investor sentiment. Specific concern surrounded a potential disruption to Russia’s oil and gas exports, which led to a further 8.4% gain in oil prices to $US95.72 a barrel.
The yield on U.S. 10-year bonds lifted by a further 0.05 percentage points to 1.83%, as continued high U.S. inflation reports maintained expectations of aggressive U.S. interest rate hikes this year. The US dollar was broadly steady.
As evident in the chart set below, global equities dipped further below their 10-month moving average – signalling a potential reversal of trend. The trend in bond yields, the U.S. dollar and overall commodities remains positive.
U.S. equity fundamentals – valuation challenges as rates rise further
Global equities are driven by U.S. equities, which in turn are ultimately driven by fundamentals.
The U.S. S&P 500 price index fell 3.1% last month, even though forward earnings rebounded by 1.6%. The adjustment came through the forward PE ratio, which declined from 20.2 to 19.3 (-4.7%). With 10-year bond yields only up a further 0.05 percentage points, the earnings yield-to-bond yield gap (EBYG) rose to 3.4% from 3.2% – which is broadly in line with its average of recent years.
The nearer-term fundamental picture for U.S. equities remains mixed. On the positive side, current expectations still suggest 8% growth in U.S. forward earnings by year-end. That said, the period of earnings upgrades may now be behind us, as growth slows and interest rates rise. Earnings downgrades are a potential new risk for the market.
Based on Fed rate hikes, and notwithstanding the Russia-Ukraine conflict, I still see U.S. 10-year bond yields eventually reaching around 2.25% by mid-year. If the earnings yield-to-bond yield gap (EBYG) holds at its present level of 3.4%, this lift in bond yields would drag down the PE ratio to around 17.6, or around 9% lower than its end-February level.
If the EBYG returns to its average of recent years at around 3.75%, it would imply a PE ratio of 16.6, or 14% below its end-January level.
Potential further downward valuation adjustments could largely negate gains from increased earnings, resulting in a fairly weak overall outlook for the major U.S. market for the year ahead.
Assuming the Fed persists with its intention to raise the Fed funds rate, key market uncertainties are:
- whether bond yields rise as much as expected, given the predicted Fed rate hikes (as to some extent the latter could moderate current inflation concerns)
- even if bond yields rise, whether the EBYG could decline to help preserve PE valuations
- whether earnings can hold up in the face of higher interest rates and further upward pressure on energy costs.
Global equity trends
Globally, some key sector trends are as follows:
- Value continues to generally outperform growth, with energy producers (FUEL), banks (BNKS) and agricultural companies (FOOD) the top three relative performers among currency hedged ETFs, compared to growth/quality exposures such as HNDQ and HQLT. Gold miners (MNRS) also enjoyed a strong performance last month.
- Among unhedged ETFs, defensive/value exposures such as global income (INCM), the equally-weighted S&P 500 (QUS) and UK stocks (F100) are performing relatively well, at the expensive of technology thematics generally – though cybersecurity (HACK) is still holding up relatively well.
In Australia, some key sector trends are as follows:
- Resources (QRE) and relatively defensive property/infrastructure and utilities sectors (RINC) are holding up most consistently of late, whereas technology (ATEC) remains under significant pressure (as is the case globally).
- Income (EINC) and fundamentally weighted large cap stocks (QOZ) are also holding up relatively well.
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* Equity theme proxies: US: S&P500; Non-US: MSCI Ex-US Developed Markets Index; Growth vs. Value: MSCI Global Growth and Value Indices; Emerging markets: MSCI Emerging Markets Index; Australia: S&P/ASX 200 Index.
** Ranking based on average of 3 and 6 month performance and 6 and 12 month performance, excluding latest monthly return performance.
*** Trend: Outright trend is up if the relevant NAV return index is above its 10-month moving average and down if the index is below this moving average. Relative trend is up if the ratio of the relevant NAV monthly return index to the return index for the MSCI ACWI is above its 10-month moving average, and down otherwise.