The valuation conundrum

 

As summer approaches in the northern hemisphere, it is time to take stock of where markets stand after this year’s two extraordinary quarters. In the space of a few months, we have seen several market stalwarts suffer shocks of an unprecedented magnitude and this has affected all three of the main asset classes that encompass diversified portfolios: bonds, stocks and commodities. In a nutshell:

• US and European real interest rates have risen by more than 100 basis points over the period
• Government bonds have lost nearly 10%¹ the most ever.
• Global equity markets fell by around 20%
• Commodities soared by more than 30%

To gauge the magnitude of this shakeout and how it is affecting the average investor's portfolio, we must look back at the returns achieved over the previous decade (2011-2021): equities delivered close to 11% on an annualised basis, bonds returned around 3.5%, while commodities lost about 4% per year. The performers that have made diversified portfolios successful over the last 10 years are exactly the ones that are being heckled this year, while those which disappointed the most over the same period (commodities) have delivered returns rarely seen previously. Is this a lasting new trend – and therefore a change in paradigm – or is it only a much-needed normalisation of traditional asset valuations?

In order to try and answer that question, we have estimated the fundamental valuations of these three asset classes, using similar inputs for all models: real GDP growth, inflation and the level of interest rates. Simple econometric models are used to link the prices of the three assets – S&P 500 as a proxy for global equities, US 10-year yields as a proxy for the global level of yields and the West Texas Intermediate (WTI) as a proxy for commodities) with the inputs listed above. These models simply use the principle of cointegration, as defined by Granger and Engle, and can be implemented using relatively simple analytical tools.

 

FIG 1. Fundamental valuations for the three key building blocks of multi-asset portfolio

Source : Bloomberg, LOIM

 

Figure 1 presents the results of this analysis. Several observations can be made:

• We entered 2022 in a unique configuration, in which stocks and bonds were jointly overvalued: US 10-year yields were 200 basis points too low, while US stocks were 90% above their fundamental value. According to these simple models, the overvaluation of bonds was the most extreme, as it was unprecedented and reflected extremely accommodative monetary policies. Commodity prices were close to their fundamental valuations.
• The current situation is quite different. With the shock observed so far in 2022, valuations have been greatly altered. US rates are now almost back to their fundamental valuation level, while the S&P 500 remains about 7% above. On the other hand, commodities now appear expensive: they are 80% above their fundamental valuations, reflecting problems faced by the supply side following a lack of investment in the sector.

The models we have used are indicative and show a slow evolution over time. They show that all assets sometimes remain above or below their fundamental levels for long periods (of around five-to-10 years). We also know that markets sometimes overshoot (higher or lower) their fundamental levels in an often exaggeration fashion before normalising.  But altogether, patient investors, and those with a more strategic investment horizon, will note that we may soon reach a time when such constructive portfolio ‘twists’ can be addressed with a long-term view.

This analysis leads us to believe that we are currently suffering a temporary rotation. The excesses linked to overabundant liquidity have partly been purged and should have opened the door to more attractive valuations for the basic building blocks of multi-asset portfolios. If growth slows over the next six months, stress levels may rise for commodities. In addition, it is wise to be aware of inter-asset-class rotations: as we have learned this year, they can be formidable.

Simply put, this year has so far been a story about the correction of abnormal valuations – we believe this risk is partly off the table now.

 

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

As the weeks go by, the data flow is becoming more uncertain in the US, Europe and China. 

In the US, the Empire State Manufacturing index maintained its low level of the previous month. On a moving average basis, it remains around 0, a level consistent with a slowdown that is not necessarily the source of a recession. The same was true for retail sales and the Philadelphia Fed Survey. The latest housing market data also showed some signs of slowing, but an opposite outcome would have been surprising given the rise in mortgage rates to the 6% zone. The National Association of Home Builders survey plunged while housing starts recorded their first significant decline for the year – enough to please the Federal Reserve which started to show signs of panic.​

In the eurozone, there is little data to go on. Industrial production in annual variation was negative in Europe as a whole and more particularly in Germany. Again, this is a sign of a slowdown but not yet an indicator of recession, given the historical values the series has taken.

Finally in China, after the rebound in leading indicators last week, consumption figures continued to point to a significantly weakened cycle. This figure also contrasted with the deployment of stimulus packages this year suggesting a stabilisation of demand in China will be a necessary step for markets to regain their confidence in that economy. Clearly, we are not there yet.

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World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).