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Inflation is raging. Interest rates are rising. There is war in Europe. Shanghai is locked down with COVID 19. But the equity market is holding up well – “I bend, but do not break” .
Since the beginning of the year, most major equity markets (with the exception of the Nasdaq) have of course fallen, but only by a modest 5% to 10% . Some have fallen more sharply, such as China, down by over 20%, but this is a specific case due mostly to domestic politics. Given the harsh conditions with which they are faced, equity markets are generally proving pliable.
This is not the case for the bond market, which has been toppled by the inflationary storm. It is not bending like the reeds, but breaking like the oak, with performance this year often much worse than that of supposedly higher-risk equities. An investor in long-term German or US bonds – referred to as risk-free as regards default – has suffered losses of close to 10% since the beginning of the year.
This is an extremely rare configuration. We have not seen global equities and bonds both chalk up such large losses for a full 12-month period in over 30 years . One asset class often offsets losses in the other. This is a harsh year for both asset classes, but bonds in particular, given their usual risk profile.
Is this relative resilience in equity markets another sign of “irrational exuberance”?
While some of the most expensively valued sectors, such as extremely high-growth stocks, did suffer from this syndrome at the peak of the COVID-19 crisis, this has, to a large extent, subsequently corrected. For example, Ark Innovation ETF, which is emblematic of this type of stock, has fallen by more than 40% over the year. But for the rest, the relative resilience of the market is not a major aberration – in spite of headwinds, fundamentals remain sound for equities. The tumult of the reporting season is confirmation of this. With a few spectacular exceptions, such as Netflix which has fallen 60% this year, the vast majority of companies have so far published results in line with or ahead of expectations, meaning that earnings expectations for 2022 require only fine-tuning. In the US, where the impact of the war in Ukraine is limited to an indirect effect on the price of some commodities, full year earnings are being revised down slightly but are still expected to grow by around 10%. Strikingly, in Europe, earnings revisions are positive . Certainly, this is primarily due to the commodities sector, which is benefiting from price inflation. In other sectors, recent revisions have been slightly downwards. But there is no suggestion of a dramatically negative outlook, even after two months of war in Ukraine and over a year of high inflation.
Part of the reason for earnings expectations holding up so well can be found in economic forecasts that are much less gloomy than might have been expected based solely on consumer sentiment, which has taken the full hit of inflation, whereas some companies are able to pass on inflation in their selling prices. The latest eurozone surveys published on 22 April are thus clearly optimistic: the composite PMI remains at a high level, rising to 55.8 versus 54.9 in the previous month. In the US, the same survey also shows a good degree of optimism, although there has been a fall in services due to delays and inflation.
While economic slowdown is not currently a major risk globally, companies are faced with two other challenges: margins and financing costs. Confronted with rising raw materials prices and wage pressure – particularly in the US – companies will see their margins fall overall. But here again, these worries should not be exaggerated as net margins are at historically high levels – expected at around 13% in the US . A decline that is properly managed and flagged in advance should not cause too much turbulence. The second challenge is of course rising interest rates and financing costs, coupled with tightening monetary policy. However, real rates, i.e. adjusted for inflation, currently remain mostly negative. Rising rates should not be a serious problem unless rates remain high, and inflation drops significantly. That is a risk, but we’re not there yet. And if this were to happen, central banks would certainly adjust their policies to loosen the reins once more.
The equity market certainly has some challenges to overcome, overall, but it is in sufficiently robust health to cope with these. The bond market does not have this good fortune – it held little attraction and was kept afloat purely by central banks, which are now removing their support. Its woes are likely to continue. But once the process of normalisation is over, its returns and appeal will recover. With time, a forest will flourish on the stump of the toppled oak in the shadow of the reeds.
Written on 22 April 2022, by Olivier de Berranger, CIO, LFDE