Inflation: Relief in the US
The rise in inflation since last year can essentially be attributed to three factors.
(1) The initial cause of the inflation outbreak was excessive demand for goods in the US, which has caused a global increase in goods prices, bottlenecks in the supply chains and high transportation costs (with the Ukraine war exacerbating supply constraints). Signs of easing are now clearly visible (shorter delivery times, lower transport costs, slight decline in demand for goods in the US and flattening goods price inflation).
(2) The sharp rise in energy prices has fuelled inflation, more so in Europe than the US. In the US, energy costs (especially oil and gasoline) have fallen noticeably, while in parts of Europe (especially Germany) natural gas and electricity prices have continued to rise massively in recent weeks.
(3) Full employment prevails in Europe and the US, which means that the classic inflation mechanisms – the passing-on of higher costs from producers to consumers and wage increases –continue to be active.
As evidenced in the July data, factors (1) and (2) will lead to significantly lower monthly headline inflation in the US (and, to a lesser extent, lower core inflation), while energy costs are likely to keep inflation high in Europe. The all-clear from central banks, in contrast, requires a weaker economy and somewhat higher unemployment rates, which are not discernible at present. (September 2022)
World economy: Scenarios from a capital market perspective
The economic data in July were weak, in both Europe in the US, but they are still consistent with a number of scenarios in the coming 6 to 12 months. The ideal scenario for the capital markets is a soft landing: recession is avoided, while economic growth slows just enough for inflation to fall gradually, supported by stabilising energy prices and normalising supply chains. In this scenario, bond yields are stable to slightly lower, and equity prices rally.
Private consumption has been surprisingly resilient in recent months, despite significant headwinds (especially inflation, energy costs and the Ukraine war). In the consumer-supported growth scenario the economy remains comparatively solid and inflation does not recede (fuelled possibly by a renewed surge in energy prices). In this scenario, central banks continue to tighten monetary policy, also in the coming year, yields on shorter-maturity bonds rise and share prices are likely to fall, despite a fairly resilient economy. The danger of recession is not averted but postponed until next year.
At the other end of the scale is a scenario of a downturn leading to a recession (which we presume to be mild, though this is not a foregone conclusion, given post-pandemic disequilibria in the US and energy woes in Europe). The downturn could be aggravated by a sharp drop in US goods demand, which is still excessive as a left-over from the pandemic, with goods price inflation (the original cause of current inflation) vanishing quickly. Energy and commodity prices would fall in response to lower demand. In this case, negative monthly inflation rates would materialise in a few months. Central bank interest rates do not rise further and bond yields fall. The verdict for equity markets is less clear, as corporate profit margins would be pressured.
Many manifestations of these scenarios are possible. At the moment, the sharp decline evident in recent economic data may suggest a recession scenario, but a more detailed look at the data makes the conclusion less obvious. The consumption-led growth scenario is supported by timely consumption data (e.g. the weekly Johnson Redbook data for the US, while in Europe high-frequency data availability is limited). A soft landing is historically not the norm and thus somewhat unlikely. (August 2022)
Central banks' economic forecasts
European Central Bank: The ECB adjusted its economic forecast in June. In terms of real economic growth, 2.8% is expected this year (after 3.7% in March, with the forecast dropping in line with the market consensus). Real GDP is expected to increase by 2.1% in 2023 and 2024, i.e. significantly above the growth potential. The unemployment rate is projected to be 6.7%-6.8% 2022 to 2024, in line with current levels of full employment. Average annual inflation (HICP) is forecast to be 6.8% this year, 3.5% in 2023 and 2.1% in 2024.
Federal Reserve: Growth remains solid according to the Federal Reserve's median forecast, keeping the unemployment rate at historically low levels around 4% in 2022 through 2024. At the same time, core inflation (Personal Consumption Expenditure Deflator/PCE) is expected to drop from 4.9% in April to 4.3% in the final quarter this year. At the end of 2023 and 2024, core PCE inflation is expected to be 2.7% and 2.3%, respectively. The risks to inflation are on the upside and the Fed would tolerate a rise in unemployment to achieve price stability, according to recent statements. In addition, the Fed wants to see evidence that inflation really is coming down before declaring “any kind of victory”.
Assessment: The ECB's and the Fed's central scenario regarding economic growth, unemployment and inflation both imply a soft landing, i.e. the central banks assume that it will be possible to contain inflation by means of interest rate hikes without significantly damaging the economy. These are undoubtedly optimistic scenarios, which cannot be ruled out, but have so far failed to convince capital market participants. Historical evidence suggests that a weaker economy is needed to reduce inflation and that interest rate hikes have a delayed effect on the economy and an even more of a lagged impact on inflation (this might be different if the sharp rise in energy prices this year will weaken the economy in the coming months sufficiently to allow the expectation that inflationary pressures will abate soon). (July 2022)
Ukraine war and the global economy
While Russia and Ukraine are not very important for the world economy (around 2% of economic output and world trade), the countries key suppliers of a large number commodities (agricultural raw materials, incl. fertiliser components, energy and metals).
Energy has become more expensive (and even-higher prices can by no means be ruled out) but has overall remained available. This also applies to natural gas in Western Europe. The situation is more critical for grain, especially since exports from Ukraine will remain constrained, and the agricultural land in Ukraine will not be planted as usual. Especially for low-income countries, the sharp rise in energy and food prices has been an enormous burden.
With the pandemic and the war in Ukraine, global supply chains have moved in the limelight as an essential economic factor. Against this backdrop, security considerations in procurement are increasingly at the forefront for many companies, as producitonmoves from "just-in-time" to "just-in-case“. At the same time, a majority of well-managed companies have proven time and again in recent years that they have diversified supply chains (with news on functioning – quite different from problematic – supply chains hardly ever reaching the public). Supply chain strategies include "dual sourcing", "near- and onshoring" and "friendshoring". There is an opportunity for reshaped supply chains to become more efficient (especially in terms of transport and the use of resources). Global competition will ensure, however, that costs remain at least as important as safety considerations. The focus is thus on optimised procurement rather than risk considerations alone.
Europe's banks are most affected by Russia's isolation from the global financial system, but the risks are manageable. Almost 30 percent of Ukrainians have fled the war so far. For Europe, this means the largest flow of refugees since the Second World War. How many of these people will eventually work in Western Europe (and thus at least temporarily increase the economy's potential growth somewhat) remains to be seen. As a result of the war, defence spending will increase, especially in Western Europe (15 NATO countries have already decided to increase military spending, and a number of European members will exceed NATO's 2% spending target in the future). (July 2022)
Inflation data show no relief
Behind the surge in inflation in recent months are, in particular, a strong upward trend in goods prices and higher energy prices. In the euro area, the figures in April and May were above economists' estimates (monthly core inflation was higher than in previous months, reaching almost 6% annualised). Headline inflation in the euro area is higher than in the US, as measured by the Federal Reserve's preferred Personal Consumption Expenditure Deflator (PCE). In the US, inflation (measured year-on-year) may have peaked in March.
With oil prices rising again, the easing of the energy component of inflation is delayed, but remains a realistic scenario in the coming months (supported in Europe by energy tax cuts in some countries). A slight easing of pressure on goods prices also seems possible later in the year. This, however, would require fewer disruptions in supply chains (and thus no further lockdowns in China) and a shift in demand towards services.
Overall, economic activity is robust and unemployment rates are historically very low in Europe and the US, with the US labour market even showing signs of overheating. Such an environment favours rising wages and companies passing on higher costs to consumers.
The monthly inflation data, especially core inflation, will remain pivotal for the capital markets and central banks, with currently no evidence of pressures easing.
An overview over the theme of inflation is provided here. (June 2022)
Equity market scenarios
In the medium term, i.e. in about three years, we assume a scenario of full employment and inflation within the central bank targets of 2%. If we feed this scenario into our Shiller price/earnings (CAPE) ratio model for the US (the model calculates a fair price/earnings ratio for the average of real corporate earnings over the past 10 years), we get a fair value of around 30. For comparison, in 2018 and 2019 the market valuation and the model averaged about 31, which also happens to be the current market valuation. The current market valuation would thus be roughly consistent with our fairly constructive medium-term scenario of full employment and 2% inflation. In a Goldilocks scenario (US unemployment rate at 3%, inflation at 1.5%), the model calculates a CAPE ratio of nearly 37. With the economy still in recovery from a mild recession in three years (unemployment rate at 4.5%, inflation at 2%), the model CAPE would be 27.
Globally somewhat lower real economic growth than before the pandemic (based on the same productivity trends as before the pandemic, slightly negative demographic factors and structurally lower economic growth in China) argues for outperformance of quality growth stocks in the medium term.
The road to the medium term will be bumpy, with phases of a more positive assessment and phases with negative news flow likely alternating. Elements of a positive scenario are lower inflationary pressures on goods markets, China’s economy operating normally again after the lockdowns and stabilising energy prices. At the same time, the European and US economy continue to grow solidly, supported by full employment. Lower US tariffs on imports from China, if enacted, would positively influence the profit margins of a number of US companies.
A negative scenario would include persistent inflationary pressures (also due to ongoing lockdowns in China) and declining corporate profit margins due to rising cost pressures (wages, energy and commodities). In a persistent inflation or recession scenario (we model an average recession with an increase in the unemployment rate by two percentage points, though we would not consider a recession a meaningful risk in the coming 12 months), the model suggests CAPE ratios of around 25 (i.e. about 20% below the current market valuation), with stock markets having fallen well below fair value in past bear markets. (June 2022)
Fed rate hikes, the US-economy and the capital markets
We have studied Fed rate hike phases since the 1970s with regard to the development of the US economy and capital markets (stocks and bonds).
Since higher interest rates impact the economy with a lag, growth was usually still solid when interest rates rose. The unemployment rate, on average, fell, and the growth of the gross domestic product (GDP) remained positive. In the past, the last interest rate hike usually took place when the first signs of a slower economic pace were already visible. On average, it took three quarters after the last rate hike for a recession to begin (the normalisation phases of monetary policy in 1983 and 1994 were not followed by a recession; the recession in 2001 was mild, and in 2020 the trigger was a pandemic-driven lockdown and likely not monetary policy).
Bond yields have risen during periods of Fed rate hikes but significantly less than the Fed funds rate, resulting in a flatter but rarely inverse yield structure (i.e. the yield on 10-year bonds has remained above that on 3-month Treasury notes).
Corporate bond spreads have tended to fall during rate hikes (i.e. corporate bonds have outperformed government bonds), which is consistent with the observation that economic growth has generally remained solid during Fed rate hike episodes.
Equity returns were below average, but slightly positive, during rate hike episodes. Of particular interest is the period in the months after the last rate hike, pointing to a strong relief rally. The stock market tended to be weaker to negative on average in the period around one year after the last interest rate hike (when the economy usually visibly weakened and the growth of corporate profits turned negative). (May 2022)
Equity markets – Advanced growth correction
Two trends have shaped stock market activity this year. The dominant trend in the US and Europe was the end of the outperformance of growth stocks. In retrospect, the last few months can be described as the bursting of the "pandemic bubble". As a second, less significant trend for the global stock markets, the Russia’s invasion in Ukraine, especially the associated very sharp rise in energy prices, has weighed heavily immediately after the start of the war.
Rather weak global economic growth, low inflation and low interest rates – as expected in such an environment – led to a strong outperformance of growth stocks in recent years. With earnings growing solidly, valuations of growth stocks have risen steadily, a trend that has been reinforced in the pandemic and has affected all sectors, not only technology. With the end of the pandemic and rising bond yields, the tide has turned: In such an environment, value stocks (i.e. low-valued, mostly low-growth companies such as financials, energy, commodities and telecoms) tend to dominate.
The valuation premium of growth stocks over value stocks has narrowed in recent months, and many growth stocks have become more attractive again. This improves the chances for more stable stock markets. We see the rotation towards value stocks to be well advanced, though likely not yet complete. (April 2022)
Equity markets: Gulf Wars 1991 and 2003
We have analysed the price trend of European and US stock indices in the run-up to and during the hostilities of the Gulf Wars of 1991 and 2003. That these wars in distant Iraq may have been perceived differently on the capital markets than a war in Ukraine, a European country, is possible but not necessarily so.
The stock market performance during the Gulf wars largely corresponds to the uncertainty profile over time. The main uncertainty relates to the question whether a military confrontation will remain local or escalate to involve more countries.
Following the invasion of Kuwait by Iraq in August 1990, and at the beginning of 2003, when a military confrontation started to preoccupy investors, share prices fell by around 20% in Europe and 15% in the US over a period of two months. With or immediately before the military operations (12 January 1990 authorisation of the military operation by the US Congress, first hostilities on 16 January; 2003 first hostilities on 20 March, with the war ending on 1 May), share prices began to recover.
If the price decline in the Ukraine conflict is assumed to last exactly two months, it would already be over now (the Russian troop build-up has been discussed as a risk scenario on the capital markets for at least two months before the invasion). (March 2022)
Growth vs. value shares
MSCI divides the overall market into two segments of equally sized market capitalisation. The MSCI World Value Index contains stocks with comparatively low price-to-book values, low price-to-earnings ratios and high dividend yields. The MSCI World Growth Index contains stocks with above-average earnings and sales growth (based on historical data and forecasts).
Growth stocks outperformed strongly in the 1990s (characterised by a technology boom) and moderately after the financial crisis until the pandemic. Since the first lockdowns in early 2020, the outperformance has been almost as extreme as in the 1990s. There is no clear correlation between the economy or monetary variables (e.g. interest rates, inflation) and the relative performance of growth stocks. However, growth stocks generally perform better when economic growth is rather subdued, which was the case in the years after the financial crisis (and will be the case again starting in 2023 or 2024 at the latest).
In the second half of the 1990s until the bursting of the technology bubble, the valuations of growth stocks (mainly technology at the time) increased sharply compared to value stocks. After a moderate valuation expansion until early 2020, valuation expansion has been pronounced again. Overall, there appears to be further relative correction potential for growth stocks this year, despite good medium-term prospects. (February 2022)
Medium-term inflation outlook
The fact that a structural break took place in the early 1990s and that inflation has remained low and comparatively stable since then is well documented in the literature. Inflation has also ceased to correlate systematically with the money supply over the past three decades.
Although explaining such a structural break is inherently difficult, there are a large number of studies on the subject. Among the factors often cited to explain the decline in inflation is globalisation (i.e. local bottlenecks in goods or labour markets do not drive prices if the global supply of goods or labour is sufficient). Although this argument is convincing, there seems to be surprisingly little empirical evidence in its support. Moreover, in an ageing society, more and more employees with high wages retire at the end of their working lives, while those entering the labour force have lower wages (the argument is particularly compelling when the productivity gap between older and younger workers is smaller than the wage gap). This demographic effect is small but statistically significant in the US, according to the Federal Reserve. Due to technological progress, many products (e.g. semiconductors) are becoming more efficient and less expensive, which contributes to product price deflation. In recent decades, the industrialisation of the retail sector (examples include Walmart, Zara and IKEA) has also led to lower prices for many goods.
Last but not least, central banks have made a significant contribution to low and stable inflation rates. The number of central banks worldwide that are independent of politics has increased (inflation falls with the degree of independence), and since the late 1980s more and more central banks have introduced a formal inflation target, which helps to stabilise inflation expectations.
Although the influence of the above-mentioned factors on inflation cannot be determined quantitatively, there are hardly any indications that these factors would reverse course in the future. All in all, a comparatively moderate inflation environment, as in the past decades, thus remains the most likely scenario in the medium term. (January 2022)
China: Medium-term prospects
China's 14th Five-Year Plan of March 2021 envisages a doubling of economic output by 2035. This corresponds to annual growth rate of 4.7%. Compared to over 6% in the past few years, economic growth is likely to nearly halve by the end of the decade.
Government focus is on innovation, the environment, financial stability and "common prosperity". Private consumption, renewable energies and innovation sectors (especially technology) are promoted as growth sectors. In contrast, the growth driver of the past, the real estate sector, is becoming less important (especially during the financial crisis, but also in the Corona crisis in 2020, the real estate sector was the main recipient of stimulus money from the central government).
The transformation in China will be accompanied by lower growth, with risks on the downside as long as the new growth drivers cannot fully compensate for the weaker real estate sector. In addition, the ageing of the population (despite the relaxed one-child policy) is contributing to a decline in potential growth. The world's second largest economy will nonetheless continue to grow at an above-average rate, though it will no longer be the world’s dominant growth driver as in the past 10 to 15 years.
Despite a somewhat slower growth pace, China's government will continue to steer economic activity very actively, making disorderly developments very unlikely.
Globally, the gradual decline in growth rates in China means less economic growth overall and thus low real interest rates. Nevertheless, China will remain attractive for Western companies, especially due to continued growth in consumer spending. (January 2022)
Equity markets: Fundamental sensitivities
We have analysed how the MSCI World, its sectors and key market segments are performing in different fundamental environments.
The overall market rises when the economy is growing, but, on average, also when bond yields or inflation rise, and monetary policy is tightened. Financials are the best sector when inflation and interest rates rise. Industrial stocks also perform comparatively well in a rising yield environment. Conversely, consumer staples, healthcare and quality growth stocks are the preferred market segments when the economy is growing only slowly, and interest rates are low, which remains our base case for the medium term. (December 2021)
China: Tighter regulation of the economy
This year has seen tightening of the regulation of internet companies in China, with Alibaba (the world's largest e-commerce company with annual gross merchandise value of over 1 trillion US dollars, more than twice as much as Amazon), Tencent (social networks with over 1.2 billion active users, payment services, mobile games, news content, videos and music) and Meituan (the world's largest delivery service) among the most prominent targets. What started with the cancellation of the Ant IPO (Alibaba's payment service) in November last year has expanded into a comprehensive set of measures focused on competition, but they also include restrictions in areas such as online games. Separately, academic tutoring – a boom sector in recent years – has been banned for for-profit organisations. In August, China also passed one of the strictest data protection laws in the world, curbing the collection and use of data by tech companies (but not by the government). The latest regulatory efforts are part of the 2021-2025 plan released in August, indicating that regulation of the economy will be a greater governmental focus than in recent years.
More competition tends to lower the profit margins of monopolists and benefit consumers and smaller merchants (who use the large platforms to distribute their products), with strong network effects (which promote monopolistic market structures) likely limiting the impact on profitability. We also believe that the regulatory measures do not go so far as to negatively affect overall economic growth. (September 2021)
Is «market breadth» a good stock market indicator?
In recent months, the equity bull market has broadened visibly, with almost all sectors and an unusually large number of companies seeing rising prices. There is an often-cited rule that a high market breadth bodes well for future returns.
As an indicator of market breadth, the proportion of shares reaching a new 52-week high is most often used (the difference between the number of new 52-week highs and new 52-week lows can also be examined. To analyse future returns we grouped market breadth into four equally sized buckets (quartiles), with the fourth quartile representing the best market breadth (i.e. the highest proportion of new 52-week highs). This year, the market breadth has been mostly in the third or fourth quartile.
We conclude from our analysis that market breadth does not give reliable signals for market direction. In particular, the share of positive stock market periods is largely independent of market breadth. Contrary to what is often portrayed, high market breadth is associated with below-average returns. High market breadth thus appears to be an indication of an advanced bull market rather than a signal for high returns or a particularly high probability of achieving positive returns in the future. The conclusions are the same if we analyse only positive market periods. (April 2021)
Interest rates and equities: Conceptual framework
In a simple earnings discount model, the relationship between the stock market value and its determinants can be represented as follows: P = E / (r + z - g). P is the price (the present value of future earnings), E the earnings of the current year (or a multi-year average, as used in the Shiller-Cape ratio), r the risk-free interest rate, g the earnings growth rate and z the equity risk premium. The risk-free interest rate r and the growth rate g are strongly correlated, both conceptually and empirically. Interest rates are high when real or nominal economic growth (and thus growth in corporate profits) is high and vice versa. If r and g are the same, the formula shortens to: P = E / z. The fair value of an equity index equals the underlying profit level divided by the equity risk premium. If the risk premium is high (i.e. uncertainties are high), P is low and vice versa. As indicators of the risk premium, inflation (i.e. current inflation and not inflation expectations as implied in longer dated government bonds) and the frequency of recessions have been empirically shown to be very important in the long term. In the short term, economic momentum plays a role, while changes in monetary policy have less influence. We conclude that a connection between stock markets and interest rates is conceptually far less compelling than often assumed. Empirically, it can be shown that both a decline and an increase in the returns of the 10 year US-Treasury of the past 20 trading days lead to an above-average stock market performance in the following 20 and 60 trading days (especially a strong increase of more than two standard deviations). In contrast, an increase in yields by one or two standard deviations indicates a slightly below-average, but by no means strongly negative, performance in the month immediately following the increase in yields. (March 2021)
Equity regions: Risk and return profiles
The US stock market is by far the largest, followed by emerging Asia, Europe and Japan (while Latin America and emerging European markets lag far behind).
With a view to returns and risk measures, it is striking that the US market enjoys a top rank for returns in each period and is also among the markets with the lowest risk (standard deviation, semi-deviation). Consequently, portfolios optimised for risk and returns have a very high US-weighting, with some allocation to Emerging Asia and Japan for diversification purposes. European investors, therefore, should hold a high share of equities outside their home region (primarily in the US and, to a lesser extent, Asia). In contrast, the case for international diversification for US-based investors is much less compelling. (January 2021)