OBSERVATIONS | THE OUTLOOK FOR EQUITIES - NAVIGATING INFLATION, RATES AND EARNINGS
Across many asset classes—global equities, fixed income and cash—real returns have been deeply negative over 2022, as persistent inflationary pressures (compounded by the Russia-Ukraine conflict) have left most central banks seemingly behind the curve in their monetary policy settings. Higher interest rates are coming at a time when global growth has slowed (US Q1 GDP was negative), creating a perfect storm for investors and raising the prospect of a stagflationary backdrop for equity markets.
In this article, we explain that the intersection of peak inflation, peak US Federal Reserve (Fed) hawkishness, and peak interest rates will govern the direction of equity markets in H2 2022. We also revisit how investors should be positioning their portfolios’ exposure to technology stocks.
- It is possible that we are at, or close to an inflection point with inflation. Breakeven inflation rates hit their recent highs near the end of March and have trended lower since then. Furthermore, CPI swaps inflation expectations, although elevated compared with year-ago levels, have also been falling over the past several months.
- Peak inflation does not necessarily mean peak hawkishness—or, at least, not yet. Futures markets are currently pricing in a February 2023 Fed funds rate of 2.92%. This compares to the 2.55% rate priced in at the end of March, despite inflationary expectations receding over that time.
- The US 10-year bond appears to have broken out of a period of delivering consistently lower yields. Global investors, starved of yield, have aggressively bid up equities with long-dated cashflows because the alternatives (government bonds) were not competitive. Furthermore, the yield on investment grade bonds relative to the dividend yield on the S&P 500 is now at its highest level in a decade. Where long-term interest rates trend over the next few years will be key to assessing valuations for equity markets.
- The recent equity market correction has rendered earnings-based valuation metrics seemingly fair (though not cheap) for the market at large. For Australia, its valuation is now trading one standard deviation from its five-year average, offering greater valuation protection and justifying our overweight stance. The critical issue for investors is whether current earnings estimates are accurate.
- For many investors, how to position their portfolio’s exposure to technology stocks is perhaps their biggest conundrum. Although many technology companies remain resilient businesses, with high returns on capital and strong balance sheets, valuations make many stocks vulnerable to any downturn in sentiment. In this period of volatility and adjustment, the best course of action is to remain well diversified within equities (by region, style and sector) and across asset classes, and to remain very cognisant of valuation risk.