By Charles-Henry Monchau, chief investment officer, Syz Bank
It seems that equity and bond markets now believe that the Fed will get inflation under control and that it will soon pause its rate hikes cycle, which is supportive for equity valuations.
Consequently, P/E ratios for US equities have expanded back to 17.5x forward earnings, leading to a nearly 10% appreciation of the S&P 500 since June 16.
Executive summary
Does this rally have legs? Is it the start of a new equity bull market?
- There are indeed some reasons to become more positive on risks assets. Despite a technical recession in Q1/Q2, the US economy is still doing relatively well. Q2 earnings have been soft, but not dismal. The Fed will remain data-dependent, which is opening the door to a less hawkish stance by the FOMC if data starts to worsen. In terms of market positioning, hedge funds are under-invested equities which means that many investors will have to play catch-up if the rally continues.
- However, from a fundamental standpoint, we believe that the macroeconomic and liquidity conditions remain a headwind for risk assets. Indeed, policymakers are facing an “inflation vs. growth” dilemma. Governments in Europe and even the US are taking various steps to mitigate the impact of rising energy prices on households’ purchasing power. While containing the economic growth slowdown, government subsidies are feeding inflationary dynamics. But if they don’t, the economic (and political) toll will be high. Central banks across developed economies have no choice but to hike rates from super-low levels as inflation has risen way beyond their target and is no longer considered «transitory». In rising interest rates amid a growth slowdown, central banks take the risk of creating (or amplifying) a recession. But if they don’t, the consequences on inflation (and on their credibility) will be heavy.
- While the market believes that peak inflation and peak hawkishness could be behind us; to our opinion, this seems to be too complacent. While inflation might be near its peak, it is likely to stay above central banks for a sustained period of time, hence forcing central banks to maintain a hawkish stance for a longer period than what is currently factored in by the market.
- Equity valuations for their part look attractive outside the US. But the S&P 500 P/E is now back to 17.5x next twelve months earnings, a level which cannot be considered as cheap in light of the various macro-economic and geopolitical risks investors are currently facing.
Upgrading equity from “unattractive” to “cautious”.
- Our tactical asset allocation process is based on five indicators. While the macro and fundamental factors are still tilted towards a negative stance on risk assets, the most dynamic factor of our process – market dynamics -has decidedly turned positive a few weeks ago.
- As such, the weight of the evidence (i.e. the aggregation of our fundamental and market indicators) have improved from “unattractive “to “cautious” on equity markets, i.e we are becoming slightly more constructive on risk assets.
- From a regional standpoint, we are upgrading US equities from “positive” to “attractive” and keep a positive stance on Swiss equities. We are upgrading Eurozone equities from “very unattractive” to “unattractive”. In light of the recent geopolitical tensions between China and Taiwan, we are downgrading Chinese equities from “positive” to “cautious”. We are also cautious on UK, Japan and EM Latam. Our least favoured market remains EM Eastern Europe equities (very unattractive).
- We keep a “cautious” stance on Fixed Income, credit spreads and rates. We keep a positive view on Commodities (with a “preference” stance on Gold) as well as a very attractive view on hedge funds.
- In Forex, we are positive dollar against all currencies. We keep an “unattractive” stance on the Euro as the Eurozone is facing a major energy crisis that is worsening the fundamentals of the common currency.
