Taking stock of markets

It may be the dog days of summer but financial markets are still busy as we digest the implications of the dramatic second quarter earnings season. Latest estimates suggest that more than 80% of the S&P500 companies reporting so far have beaten earnings expectations, although this has a lot to do with companies issuing very pessimistic guidance in a bid to ensure a positive surprise and hopefully a boost to equity prices. It is an old trick but it seems to work and one of these days investors will get wise to it. Nonetheless, it has helped equity markets along with the S&P500 now just 1% shy of its mid-February peak.

Regular readers will recall I expressed concerns prior to the March sell-off that equities were overvalued. You might therefore think that the recent rebound is a cause for concern. But I am less concerned about the recent rally than I might once have been. For one thing, although risk indicators such as equity option volatility continue to edge lower, the VIX is still trading above its long-term average. It is notable that the VIX has come off its mid-March high of 83 to current levels of 22 (long-term average: 19.4) far more rapidly than in the wake of the 2008 collapse when it took 13 months to fall from the September 2008 high around 80 to levels around 22. This is one illustration of the impact that central bank liquidity provision has had on markets. In 2009 it took a while before markets realised that central banks were serious about ongoing liquidity provision. A decade on, markets have accepted the message that central banks mean what they say about providing all monetary support necessary and are investing accordingly. With no sign that central banks are about to pull the punchbowl, the liquidity support underpinning markets will be in place for a while.

Indeed whilst it is easy to make a case that prices are out of line with fundamentals, an environment of zero interest rates renders conventional metrics such as price-to-earnings or price-to-book ratios meaningless. This appears to be a market where investors feel they need to be invested in order to get some returns – after all, dividend yields continue to look attractive. It is possible that investor positioning will change once fund managers get back to work after the summer break, which is one reason why we see so many equity crashes in the autumn. But it is difficult to see where else investors can put their funds to work for a better return.

For all that equities might appear excessively valued, estimates of the equity premium are on the rise. The ERP reflects the required excess return over and above the risk free rate and past experience suggests it declines at a time when investors become less discerning about what they buy. On my estimates, which assume long-term dividend growth rate of 3.6%, the UK ERP is running at 820 bps. This is slightly down on the March peak of around 920 bps but is nonetheless high in the context of the past 25 years (chart 1). To a large degree, the rise in the ERP reflects the fall in bond yields whilst investors have not yet adjusted down their required earnings in view of the changed macro environment. Indeed, in a world in which trend GDP growth is lower due to slower population growth and limited productivity growth, and in which the Covid crisis will impact on earnings, so expected equity earnings are likely to adjust downwards. It appears we are in a world where investors expect a return to some form of “normality” as the current crisis passes. But just as the 2008 crash pre-empted a change to a new normal in the equity world, so Covid may be the catalyst for a “new, new normal.” Bottom line: Look for the ERP to edge lower in the medium-term.

However, we cannot afford to be complacent. Mounting fears of a second Covid spike, which could impact on the economy, and rising geopolitical tensions are good reasons for investors to raise the weight of safe assets in their portfolios. Nowhere is the flight to safety more evident than in gold where the price has established a new record in recent weeks above $2000/oz. I do have some concerns about how much further it can go. According to the World Gold Council, there were record flows into exchange traded funds over the first half of the year. To the extent that ETFs represent shadow demand for gold, and to the extent that a change in risk perception could see a sharp reversal of investor positions, there is a nagging sense that we are operating in elevated territory. That said, as with equities, there are no good reasons to expect an imminent downturn. After all, one of the conventional arguments against holding gold is that it is a non-interest bearing asset. But so, too, is cash these days. If the opportunity cost of holding gold is effectively zero it makes sense to overweight it in these turbulent times.

As a final thought, I have read a lot recently suggesting that investors’ fear of inflation as a consequence of recent central bank liquidity provision is one of factors driving gold higher. But evidence in support of the view is lacking. The break-even yield on 5-year Gilts, which reflects the difference between yields on conventional and index-linked bonds is currently running in negative territory at -8bps versus 60 bps at the start of the year (chart 2). Even the 10-year breakeven is trading at just 13 bps. To the extent that the breakeven rate reflects expected inflation over the lifetime of the bond, the data suggests that investors currently fear the current crisis will be disinflationary – or even outright deflationary – rather than adding to price pressures. In my view, the gold price surge reflects ongoing global uncertainty. It makes sense after all – an unprecedentedly high gold price reflecting unprecedentedly uncertain times.