With little sign of inflationary pressures abating, the anticipated trajectory of central bank policy rates is steepening. Although this will challenge equity returns, the asset class should still outperform fixed income. Our preference is for equity exposure in markets with attractive valuations and supportive monetary/fiscal policy, namely, China and Japan.
In the first quarter of 2022, two main factors drove equity market volatility: A reassessment of the policy rate outlook in the US, and the war in Ukraine.
Valuations – too high or about average?
Initially, the compression of multiples driven by rising real yields offset a positive earnings outlook, but as earnings season results begin to come in the market recovered. Then, with the outbreak of hostilities in Ukraine in late February, real yields fell well below where they had started the year. Equities followed suit on investor concerns about the growth outlook.
In late March, concerns about the impact of the war on economic growth (if not on inflation) eased somewhat as the worst consequences had been avoided. As the first quarter closed out, investors had also become more confident that Russian oil and natural gas would continue to flow to Europe. Europe needs Russian gas as much as Russia needs European cash.
Meanwhile, central banks have signalled that they are more concerned about the inflation outlook than any risks to growth from the conflict. As a result, monetary policy will tighten more – and sooner – than previously expected.
One might have anticipated that expectations of rising policy rates would weigh on markets again as they had at the beginning of the year. However, so far at least, equities seem to be ignoring the threat. This may be because the policy rate outlook has not yet been entirely reflected in real yields as worries about Ukraine are still weighing on market sentiment (see Exhibit 1).
Moreover, financials conditions are still very loose. The US Federal Reserve (Fed) has belatedly acknowledged that it is in fact far too loose given the level of inflation and US economic capacity, but there’s a limit to how fast it can normalise.
To judge by the most recent Fed ‘dot plot’, within two years policy rates will have reverted to neutral. The risk to equities (alongside the risk of recession), should only arise if the Fed needs to move further into restrictive territory in order to return inflation to its target.
If, as one hopes, the Ukraine war is resolved sooner rather than later, will the jump in policy rate forecasts lead to a replay of the beginning of the year, with equity markets falling? We do not believe so.
It was inevitable that as the markets priced in higher policy rates and anticipated quantitative tightening, valuations would begin to revert to pre-QE (quantitative easing) levels. The only real question was how quickly this normalisation would happen and how far it would go. If it was swift, equity prices would fall as multiples compressed, even though earnings were rising. That is exactly what happened.
Now that valuations have improved, however, we believe the adjustment will be smoother. Though the recent inversion of the US yield curve has raised worries about an imminent recession, we feel this remains a distant prospect. Even with the drag on consumption from higher inflation, the reopening of the economy following pandemic lockdowns means GDP is still forecast to expand by 3.5% both in the US and Europe this year.
In the meantime, corporate earnings will continue to rise, which is always the fundamental driver of equity prices. Despite a poorer economic growth environment than a month ago, aggregate earnings growth forecasts have not fallen. This is because negative revisions in many sectors have been offset by positive upgrades in commodity sectors
Earnings growth expectations for Europe are still robust, at around 8% a year for the next two years. Valuations, are average. Although the Fed will certainly be more aggressive than the ECB and the Bank of England, rates are rising and, in Europe, quantitative tightening is imminent.
We thus see little reason to be overweight European equities currently, in contrast to the beginning of the year when we anticipated that economic reopening and attractive valuations would lead the market to outperform (which it did).
The US market will benefit, as it often does, from higher earnings growth. That was also true at the beginning of the year, however, and it did not prevent US equities from underperforming the rest of the world as markets realised real interest rates were normalising far quicker than expected. The US market became a safe haven once the war broke out, but the focus is returning again to the policy rate outlook.
The poor returns for Chinese equities over the last year explain almost all of the underperformance of the MSCI Emerging Markets index relative to the MSCI World index. This lag in returns was not without cause. The regulatory crackdown by the government on many sectors of the economy caught investors by surprise, and China’s zero Covid strategy, while keeping deaths to a very low level, has had economic consequences. The result was earnings growth last year of just 1% when EPS rose by 50% in the US and 60% in Europe.
After such significant underperformance, the conditions seem good for a turnaround. Earnings growth at 12% is expected to outpace most other regions this year. Recent government announcements promising support for economic growth, an easing of the regulatory crackdown and support for the property sector seem to signal a significant change in course.
Relative valuations also look attractive to us and we believe Chinese equities will perform better given the significant divergence in the outlook for monetary policy. Markets anticipate policy rates rising by 240 basis points (bp) in the US, and by 111bp even in the eurozone over the next year. By contrast in China, they should drop by 90bp.
We also favour Japan, where rates could rise by 5bp. A combination of looser monetary policy, currently negative sentiment and a strong earnings recovery could be a powerful driver of returns this year.