Published On: December 16th, 2021|By |Categories: Market Updates, Value|5.4 min read|

Last week we highlighted our view on the main market risks entering 2022. Omicron was not one of them. The extreme longer lasting social and economic scars of stringent lockdowns has become very apparent and made governments more loath to resort to such extreme measures. Furthermore, after almost two years of dealing with the virus, companies and individuals have become more adept at circumventing remaining restrictions. This reality is borne out in the chart below which shows the four global waves of Covid in the top clip. The second clip shows the global composite PMI (measure of strength of global manufacturing and service activity). What is apparent is that after the initial massive contraction in economic activity after the onset of Covid, subsequent waves of the virus have not barred economic growth at the global level.

Global Covid Cases vs. Composite PMI and MSCI ACWI

Source: NDR

The main risk in our view remains the impact which persistent high inflation is having on the willingness of Central Banks to retain their extreme accommodative monetary stance. This past week the U.S. recorded its highest annual increase in headline inflation (+6.8%) since 1982, while jobs data pointed to a strengthening labour market that is already close to full employment. Jerome Powell has retired the use of ‘transitory’ to describe inflation and is expected this week to increase the pace of the Fed’s QE taper. The Fed’s willingness to fight inflation rather than inflation itself may be the deciding factor in whether 2022 will provide the types of returns to which investors have become accustomed.

The chart below shows that other central banks across the globe are well ahead of the Fed in their determination to fight inflation. At the end of last year, more than 90% of central banks’ last rate change was to lower rates. Today that is just 55% and falling sharply. So far, interest rate increases have been primarily contained to emerging markets (whose equity markets have coincidentally lagged returns in the developed markets by a considerable margin).

MSCI All Countries World Index vs. Breadth of Central Bank Rate Changes

Source: NDR

We have frequently noted the inverse relationship between rising inflation and interest rates, on the one hand, and lower valuation multiples, on the other. The Rule of 20 has been a simple yet effective gauge of determining whether the market is rich or cheap. Since 1970, the sum of the market’s PE and the year/year change in the CPI has averaged 20. Significant time above that figure warrants caution, while a sum below 20 represents the emergence of some value. Today, the sum of the forward multiple on the S&P 500 and the CPI is 27.8 (21+6.8), more than two standard deviations above the long-term mean and resting at levels that exceed the go-go years of the late 1960s and rivaling those seen at the height of the bubble. Even if inflation were to halve from current levels, the market would still be deemed expensive by this measure. It does seem inevitable that valuation multiples will need to decline to remain sustainable in the context of structurally higher inflation and interest rates.

Rolling "Rule of 20": S&P 500 NTM P/E plus CPI Y/Y

Source: Strategas Research Partners

Glancing at the strength of the major equity indices, one might induce that the contraction in valuation multiples is still some ways off. However, as the following two charts will show the process is well underway and being masked by the continued price momentum in the largest capitalised shares. Firstly, the set of four charts below show the prices of securities that represented some of the most speculative segments of the market in 2020 – IPOs, the ARK ETF (long-shot disruptors), Gamestop (a ‘meme’stock that was the target of retail investor enthusiasm), and the Solar ETF (beneficiary of mass capital flows into clean tech). In all cases the stock charts tell the story of unrestrained enthusiasm followed by the onset of emerging realism.

Renaissance IPO ETF | ARK Innovation ETF | Solar ETF | Gamestop

Source: Bloomberg Finance

The gravity of rising interest rates is certainly being felt in the cohort of most expensive shares. The chart below shows the difference in earnings multiples between the top 20% most expensive shares and the 20% of least expensive shares in the U.S. market. The valuation spread has narrowed significantly in 2021. However, this valuation spread still remains stretched by any historic measure and, despite some contraction, is still above the spread induced by the tech bubble of 2000. Indeed, the valuations assigned to this most expensive segment of the market would need to fall by another -37% just to return to the historic average.

Median Price To Earnings Spread Between High P/E Stocks (Q5) vs. Low P/E Stocks (Q1)

Source: Bloomberg Finance

Looking at the sector breakdown of the current constituents for the low and high P/E stocks shows that nearly half of the low P/E stocks are comprised of financials, with another significant chunk of companies from the discretionary consumer sector. The high P/E stocks are slight more diversified with the majority found in tech (no surprise) and healthcare (mainly high-flying biotech and medical tech companies). In our view, these are the segments of the market most at risk from the scenario of higher inflation and interest rates.

Sector Breakdown of Low P/E (Q1) & High P/E (Q5) Stocks

Source: Bloomberg Finance

While these extremely highly valued companies have already started the process of normalization, there is one segment of the market that may also be at risk and would have an even greater impact on the direction of index returns – the mega-cap technology companies. The top five companies in the S&P (Apple, Microsoft, Alphabet, Amazon, and Tesla) now have a combined market cap approaching $10 trillion and represent almost 24% of the index. Investors have judged these companies to be all-weather holdings that will perform in all macro conditions. However, what is interesting and concerning at the same time, is that in 2021 their share of the index has continued to grow even though their share of earnings (chart below) has actually begun to shrink. Other companies are growing earnings at a faster rate yet the market cap of the Fabulous Five keeps expanding and with it the valuation risk of this segment of the market.

Market Cap vs. Net Income Weight of Top 5 Largest Companies In the S&P 500

Source: Strategas Research Partners

Focussing our attention more on the near-term outlook for the market, the early indications remain positive. We highlighted in the last update the two charts which we are following very closely to determine the risk of a monetary policy error leading to a significant growth slowdown. These charts have been updated and presented again below. The recovery in equity prices last week has been accompanied by a steepening in the yield curve, albeit small (first chart), and a decline in the corporate yield spread (second chart). Both these short-term developments are evidence of a small rebound in the confidence for future growth and exactly what we would want to see to justify a continued march higher in equity prices. However, both charts bear further attention, and we will not want to see any future decline in equity prices accompanied by any deterioration in these charts.

U.S. 10yr/2yr Yield Curve

Source: Bloomberg Finance

S&P 500 | U.S. High Yield CDS

Source: Bloomberg Finance


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David Williams (1970) is responsible for the investment policy of Mpartners. After a brief career in diplomacy with the Ministry of Foreign affairs in Barbados, David joined Insinger de Beaufort asset management in 1997 and became a director in 2002. He was responsible for the investment team and the investment funds (long-only and hedged). His specialism is European equities. David holds a B.A. (Hons) from the University of Kent, an M.Sc. from the London School of Economics and an M.B.A. from Nijenrode university.