WRITTEN BY CHIEF INVESTMENT OFFICER, GEORGE HERMAN
Since our previous edition of Peregrination, global growth expectations have declined further, and recession probabilities increased further. We have also had more inflation scares and interest rate hikes. If your gut twists whilst reading all this, you’ll have to handle Maarten’s economic update article with care.
This inflation and interest rate scare is the first of its kind in 40 years, so it has hit the financial markets like a rebalancing tsunami. Now, reacting to the current cycle, the financial markets have also supplied some of their own gut-wrenching experiences, as this negative cocktail, of inflation and interest rate hikes, has caused severe volatility in all major asset classes. All the interdependent relationships in the financial world are being shaken by higher risk-free rates; all future values need to be marked lower, and all risk premiums increased. Within the context of the Russia-Ukraine war and a massive return of interest rates and risk premia, financial markets have become extremely volatile as they try to find new equilibria.
While bond market yields soared higher on the back of high and clearly more persistent inflation, equities, on the other hand, are valued by expected earnings multiplied by a valuation multiple. This multiple is directly linked to risk sentiment and liquidity. Equity markets thus devalue rapidly as risk sentiment deteriorates. In recent weeks, this has happened so fast that expected earnings haven’t yet been marked lower. Current equity valuations now fairly reflect the current rate and liquidity environment but are based on earnings which clearly don’t reflect the deteriorated economic growth trajectory.
The graph below shows the S&P Index (orange) along with one-year forward expected earnings (black). This graph shows how the equity market is indelibly linked to earnings and we know earnings are linked to economic activity. See the current one-year forward earnings expectation in the red circle? It hasn’t budged yet! It’s exactly at this point where we find the risk posed to equities at this juncture. By how much will earnings expectations decline by the end of this year and where will next year’s earnings be anchored? This will largely depend on how the global economic path plays out and how restrictive monetary policy ultimately becomes.
Once we look beyond the one-year horizon, it looks like the world will have been through the worst of this normalisation shock to the system and interest rates will likely be lowered again. This will once again allow equity valuations to return to a more optimistic setting and for bond and equity markets to percolate.
I finished off last quarter’s missive with the adaptation of the famous quote from the movie Jerry Maguire to “Show us the earnings!”. Well, the entire world is waiting, and this coming earnings season promises to be as much of a blockbuster as Tom Cruise’s latest movie – strangely, a return to the 80s with a rebooted Top Gun.