David Bassanese | Feb 02, 2022 14:02
Global equities suffered a sharp fall in January as rising bond yields placed downward pressure on price-to-earnings valuations, especially among growth stocks.
The yield on U.S. 10-Year bonds surged 0.27 percentage points to 1.78%, as high U.S. inflation reports and hawkish commentary from U.S. Federal Reserve officials ratcheted up expectations of aggressive U.S. interest rate hikes this year. Global equity prices dropped 6.1%, while the $US firmed by 1%. Strength in Oil and agricultural prices saw commodities overall rise 6.6%.
As evident in the chart set below, global equities dipped below their 10-month moving average for the first time since early 2020 – signalling a potential reversal of trend. The trend in bond yields, the U.S. dollar and overall commodities remains positive.
Global equities are driven by U.S. equities, which in term are ultimately driven by fundamentals.
The U.S. S&P 500 price index fell 6.9% last month. As evident in the chart set below, this reflects both a drop in the price-to-forward earnings ratio and a small drop in forward earnings. The forward PE ratio dropped from 21.1 to 20.3 (-3.8%), while fear of higher interest also saw a small 2% fall in forward earnings.
The nearer-term fundamental picture for U.S. equities remains mixed. On the positive side, current expectations still suggest 9% growth in U.S. forward earnings by year-end. That said, the period of earnings upgrades may now be behind us, as growth slows and interest rates rise. Earnings downgrades are a potential new risk for the market.
Rising bond yields since late last year, moreover, have so far been largely met by a further narrowing in the earnings yield-to-bond yield gap (EBYG) from 3.5% to 3.2%, which is at the low end of its range of recent years. As a result, the PE ratio has only dropped modestly in recent months, to be still at 20.3 times earnings at end-January, compared to an average of 17.5 in recent years.
Based on Fed rate hikes, I still see U.S. 10-year bond yields eventually reaching around 2.25% by mid-year. If the earnings yield-to-bond yield gap (EBYG) holds at its present level of 3.2%, this lift in bond yields would drag down the PE ratio to around 18.3, or around 10% lower than its end-January level.
If the EBYG returns to its average of recent years at around 3.75%, it would imply a PE ratio of 16.6, or 18% below its end-January level.
Potential further downward valuation adjustments could largely negate gains from increased earnings, resulting in a fairly weak overall outlook for the major U.S. market for the year ahead.
Assuming the Fed persists with its intention to raise the Fed funds rate, key market uncertainties are:
The chart set below outlines trends in several key ‘thematic tilts’ across global equity markets.
As evident, although U.S. market relative performance slipped a little last month, the trend still remains up. Similarly, while emerging markets enjoyed a relative performance bounce the trend so far at least remains downwards. There has been a clearer trend shifts in terms of factors/sectors – with cyclical sectors turning down relative to defensive sectors, and value again beginning to outperform growth.
The table below sets out a selected list of BetaShares ETFs across various regional, sector and factor thematics.
In Australia, some key ETF sector themes are as follows:
Globally, some key ETF sector themes are as follows:
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