Ron Leven analyses the macroeconomic landscape, noting the looming shadow of inflation, the overvaluation of equities, the continued growth in real estate and the prospects for the U.S. dollar against the euro and the yen.
- During 2022, with the influence of COVID-19 potentially waning, the pivotal macroeconomic issue may be higher inflation, the threat which has now manifested from theoretical to actual.
- The continued rise in equities means that they now appear to be overpriced when compared with economic performance.
- Meanwhile, real estate prices have continued to rise and the strength of the U.S . dollar will depend on how the Fed deals with inflation.
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Despite last year’s amazingly quick discovery and roll out of vaccines the uncertainties of the year ahead are to a large extent a continuation of last year’s issues.
Macroeconomic outlook still influenced by COVID-19
The resurgence of COVID-19 via the Omicron variant keeps the extent and length of dislocation as a wild card making the future still highly uncertain. That said, Omicron is following the typical virus pattern of variants becoming more contagious but less lethal so there is reason to hope that by this time next year COVID-19 will no longer be a consideration.
As noted a year ago, the equity market negative reaction to COVID-19 was short-lived and it steadily recovered to finish 2020 near record highs, about 15 percent stronger than the pre-pandemic high.
Despite COVID-19’s persistence in 2021, the rally extended until late in the year as concerns of a potential tightening of Fed policy began to weigh on sentiment. But like last year, the market closed near a record high; up 22 percent from the 2020 close. Hence, the question of whether stocks are excessively expensive, persists.
The widely reported surge in real estate prices makes this asset class also suspect of overvaluation.
One evolution over the past year is that the threat of higher inflation has gone from theoretical to actual and the nature of this inflation is probably the most pivotal issue for performance in the year ahead.
Equities are no longer cheap
An ongoing theme in this publication in recent years is that while equity valuation – measured by either price/earnings or dividend yield – was expensive by historical standards it was not expensive relative to alternatives.
This is a key consideration because selling equities on the basis of overvaluation only makes sense if there are better valued alternatives.
For fixed income, the traditional alternative to equities, the answer to this question has generally been that there is little motivation to switch out of equities.
Prior to the pandemic, equity dividend yield was on average modestly – 16bps – lower than the 10-year Treasury bond yield and more significantly lower – 88bps – than AAA corporate bonds.
In the panic market selling in early 2020, the dividend yield moved to an unprecedented positive spread to both benchmark yields, making equities historically cheap on a relative basis.
The spread mean converged over the course of 2020 and through much of 2021, reflecting both a 30 bps drop in dividend yield and about 60 bps rise in bond yields.
But the convergence in 2021 has narrowed the spreads just back to the pre-pandemic end-2019 levels, which is roughly in line with the historical average.
Despite the continued equity rally and higher bond rates, equities may not be cheap but, relative to the bond markets, they are still not expensive.
Figure 1: SPX dividend yield vs 10Y U.S. Treasury and AAA corporate bond rates
Figure 2: SPX market cap vs GDP and the U.S. Treasury (10Y vs 3M) yield curve (Year-end data)
A year ago, we noted a discrepancy that while equities were not expensive relative to fixed income, they were expensive relative to the general conditions in the economy and this discrepancy became more extreme in 2021.
As shown in Figure 2 above, for the 20 years prior to the pandemic the ratio of the SPX market capitalisation to the level of GDP generally remained in a range of 70 percent to 110 percent but the 2020 rebound took capitalisation to an unprecedented 150 percent of GDP.
Gains versus GDP persisted in 2021, and the close of the year saw capitalisation over 170 percent of GDP.
To some degree the extreme valuation in 2020 could be blamed on COVID-19 generated distortions on GDP as the lockdown forced much of the economy into forced underemployment and excess capacity creating potential for a snap back in GDP as conditions normalised.
But as we enter 2022 this explanation no longer holds water as the unemployment rate is back below 4 percent and capacity utilisation at 76 percent is in line with the historic average – if anything, GDP growth is likely to slow.
The yield curve adds to the picture of equity market overvaluation relative to the macro-economy. Historically, equity valuation relative to GDP has tracked the 10Y vs 3M US Treasury bond yield curve with a flatter curve associated with lower equity valuation.
Expectations of Fed tightening has pushed up short-term rates, so the curve flattened significantly this year making equities look overpriced.
This leaves us with a somewhat mixed picture for equities. They remain reasonably valued relative to the bond market but extremely expensive relative to economic performance.
This divergence is probably a factor in the topping out in prices since the start of the year. It also appears that equities could become quite vulnerable if bond rates rise, creating a more consistent picture of equity market overvaluation.
Watch: Refinitiv Eikon – The ultimate set of tools for analysing financial markets
The market believes in Goldilocks
The emergence of inflation and expectations of an imminent Fed rate hike is probably the biggest change in market expectations from a year ago.
The orange line in Figure 3 below, shows what the futures market has been pricing for the change in Fed funds rate over the next two years.
At the beginning of 2021, the futures market was priced for Fed funds to remain flat through the end of 2022 but with inflation now at its highest levels in over 30 years the market is now anticipating hikes by the end of this year and nearly a 150 basis points in hikes overall by the end of 2023.
Expectations of Fed hikes are already firming short-term rates, which is reflected in the flattening of the yield curve noted above.
The flatter curve indicates that long-term yields have been less sensitive to higher inflation. The 10Y rate has firmed in recent months, but at 1.79 percent it is roughly at the end-2019 pre-pandemic level, when inflation was still, at most, a theoretical concern.
As shown in Figure 3, the combination of the bond rate at still historically low levels while inflation has surged has created an unprecedented drop in the CPI inflation-adjusted real 10Y rate.
The markets seem to be relying on a very deft hand by the Fed: bonds are saying the Fed will raise rates enough to quickly contain inflation, while equities are saying they will not raise rates so much that the economy will go into recession.
The bottom line is that 2022 appears much more precarious for markets.
Failure by the Fed to contain inflation will be poorly received by the bond market, while too much tightness could send real GDP growth and stocks into a nosedive.
In the October Market Voice, we noted that wage growth and unemployment seem to be reverting back to the stronger link that prevailed prior to the financial crisis.
If the stronger link is maintained, then inflation is likely to be more persistent than the market expects, suggesting that more Fed hikes are coming than the market is priced for.
Figure 3: Real U.S. 10Y Treasury rate and expected Fed tightening through 2023
What about real estate?
Even more than the gains in equity, a major theme of the past year has been the broad rise in real estate prices.
In part this has been blamed on a COVID-19-driven relocation of households to less dense regions and – as is true in so many markets – a lack of supply.
While the price gains have been relatively stronger in suburban communities and smaller cities, major cities are also seeing firming house prices, suggesting the price gains could be an indirect by-product of overvaluation of other asset markets, as well as the increasingly low real rate of interest.
Unlike equities, there is little evidence that real estate prices are precarious.
The blue line in Figure 4 shows the total value of commercial and residential land in the U.S. relative to the SPX. The line has risen this year showing that real estate gains have outpaced equity markets, but the surge still leaves the ratio well below historic levels.
Perhaps more importantly, the cost of household related debt servicing also remains historically low relative to disposable income. While higher bond yields – and thus mortgage rates – could cool off the real estate market, a significant decline in prices looks unlikely.
Figure 4: Is the real estate market overpriced?
Goldilocks is also helping the dollar
Figure 5 shows the JP Morgan broad nominal trade-weighted dollar exchange rate.
There is a long history of the dollar’s general performance having ties to the yield curve, with a flatter curve generally dollar bullish.
Consistent with this, the curve flattening in 2021 was accompanied by general dollar strength. Whether the dollar strength extends into 2022 depends on the Fed’s reaction function to inflation.
If the Fed is successful at containing inflation, the curve should remain flat or possibly invert – further keeping the dollar strong – but if inflation persists and/or the Fed fails to rise rates in line with expectations, then 2022 will not be a good year for the dollar.
Figure 5: U.S. yield curve and the nominal trade-weighted dollar
Monetary conditions paint a more mixed picture for the dollar. 10Y European government rates (proxied by German Bunds) have gained significantly against U.S. Treasuries, but the EUR has strengthened in line with the spread gains.
As shown in Figure 7, the EUR is roughly consistent with the current spread level so, as with the broad dollar, the EUR should remain fairly stable in the months ahead.
The same is not true with the JPY. Although the Treasury spread versus Japanese bonds has risen modestly in the second half of 2020, the spread suggests the USD should be at least 10 percent weaker than current levels.
The implication is that the JPY could see some significant strength against both the USD and the EUR over the course of 2021.