Since the coronavirus-induced market crash last year, equity markets have staged a remarkable recovery fueled by central bank lowering rates and the reopening of economies following lockdowns. As with previous global recessions, monetary and fiscal policies have become expansionary. Policy rates have reduced to record lows in most major economies. Central banks have injected liquidity into financial markets through asset purchase programmes at an extraordinary rate. Unprecedented fiscal support has buffered economic activity but falling government revenues have sharply widened fiscal deficits in several countries. The result of all these actions? Equities, both in South Africa and across the world, are expensive. This is evident when you compare the rapid increase in equity prices over the last 12 months to other periods in history.
The human heart rate is a good indicator of the state of your activity. A low volatility heart rate indicates a body of rest, whereas a rise in the average heart rate volatility is an indicator of activity. Similarly, returns are the heart rate of financial markets.
Price momentum, the speed at which investment returns are generated, can serve as a useful measure of financial markets' state and an indicator of the relative performance that investors expect from the different asset classes in the near future. Using this measure, we find that the differential return of equities over bonds is currently three times higher than its historical average. This shows that investors worldwide are extremely positive that they will receive good returns from equity markets than from bond markets.
Historically, there have been only nine periods where investors have been this exuberant about the prospect of future equity returns relative to bonds. However, unlike during other positive sentiment periods when you would expect the continuation of good returns from equities, history shows that disappointing returns have often followed this extremely positive sentiment level. Here, South African equities have underperformed bonds by an average of 7% over the subsequent 6-month period, after recording excessively high sentiment levels. Market sentiment, by definition, is the aggregate of market expectations and investor behaviour and can be a strong indicator of future relative asset returns.
But why have investors becomes so overly optimistic about equity markets? It is a combination of overconfidence and a psychological bias caused by what is known as the halo effect of sentiment. Assets with extremely positive sentiment are perceived to have low risk and high future returns regardless of the underlying fundamentals. The S&P500 and FTSE/JSE All Share indices have reached record levels over the past 6 months, yet the global economy remains highly vulnerable. Firstly, despite the ensuing recovery, the global GDP level in 2022 is expected to stay 2% below pre-pandemic estimates. Secondly, the recovery of company earnings will not be as swift as many expect. For example, in their 2020 annual results commentary, Nedbank targets recovery of earnings to the 2019 base by 2023! It should serve as a warning sign that equity market sentiment is higher today than pre-pandemic levels when output was much higher. Perhaps it is simply a case of misplaced euphoria after the world has found a vaccine solution to the once insurmountable coronavirus pandemic. In their most recent economic outlook, the IMF also notes that asset valuations appear to be stretched in several markets. Complacency seems to permeate financial markets as investors seem to be betting on a persistent policy backstop - this raises the risk of a price correction.
So, equities are expensive relative to bonds. We wish investing were this easy! Historically, there is one period where equities outperformed bonds despite recording extremely positive sentiment – in 1980. In 1979, there was a significant spike in oil prices following the Iranian revolution, with prices more than doubling, from $17 per barrel at the start of the year to $40 per barrel. The rise in prices resulted in weaker global economic growth and an inflation spike in oil-importing economies. In response to rising domestic inflation, the U.S. Federal Reserve under Chairman Paul Volcker raised the federal funds rate from 11 percent in 1979 to a high of 20 percent in June 1980. The associated sharp jump in global interest rates was rapidly transmitted to the cost of borrowing. Many economies experienced currency crises and were forced to repeatedly devalue their currencies, with some seeing hyperinflation episodes in later years. During this period, SA inflation rose by 2,8%, and equities outperformed bonds.
Will inflation rise by more than current market expectations, and are we entering a rising interest rate cycle? Year to date, estimates for 2021 inflation, globally, have been revised upward, and 10-year bond yields have recently begun pricing in higher inflation. Although we tend to devote our focus to the impact that the pandemic has had on the consumer, we should not forget that a sizable part of the pandemic’s macroeconomic impact was in the form of a supply shock. Global recessions are associated with - depressed capacity utilization that discourages investment and human capital loss due to persistent unemployment. If fiscal policy efforts cannot reverse this supply-side damage, inflation may resume at a faster than expected pace in the medium-term, prompting unexpected interest rate increases. A sharp rise in inflation and interest rates is bad news for bonds.
So, equities may be cheap relative to bonds if inflation surprises on the upside. Investing is filled with many such conundrums. We think that today's record-high debt levels, across the world and not just in SA, will delay the rising interest rate cycle despite the onset of rising inflation. For now, we are inclined to believe history – extremely positive equity market sentiment is overdone.
Lima Mbeu Investment Managers (Pty) Ltd is an authorised financial services provider in terms of section 8 of the Financial Advisory and Intermediary Act, 2002, FSP number 49018, Registration No 2017/399814/07. This document is for information purposes only. Past performance is not indicative of future performance. The information contained herein is derived from sources which are believed to be reliable. Any opinion expressed herein is based on the presenter’s current analysis and is subject to change. This presentation does not constitute an offer to sell or a solicitation to buy any security. Lima Mbeu has a conflict of interest policy which outlines how conflicts of interest are managed. This policy, as well as additional information about Lima Mbeu’s products, is readily available upon request or on our website: www.limambeu.co.za
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