As markets continue to gyrate between concerns over recession and worries over persistently high inflation in the wake of the annual Jackson Hole conference of central bankers, we note that US bonds and equities have very much moved in lockstep. Notably in Europe, our valuation frameworks now point to considerable downside still for equities.
Both US equity and fixed income risk premia have recently ticked up to similar levels, but are around 100bp below where they were in June. Fixed income moves have been limited somewhat by tighter US high-yield spreads.
In equities, earnings expectations have held (surprisingly) steady. Valuations appear rich in the context of where trend earnings are and should be at this point in the cycle.
For instance, a return to trend earnings for US equities would point to a 20% fall in total returns; a halfway move to trend would suggest -12% or so. While after a correction, the tech–heavy Nasdaq index now looks less frothy, also compared to the broader US market, we believe the segment remains particularly vulnerable in a rising rates scenario.
Within equities, China and Japan are the outliers. Attractive valuations means we favour them. Set against a cautious view on Europe, we are neutral on equities overall (see table below).
As for fixed income, the UK is arguably in the ‘eye of the storm’ of rampant inflation and associated policy pressures. The UK bank rate is now priced to peak at 4.5% in six months’ time, at around the same time as the zenith in US and euro policy rates. Here the expected peaks are 4% and just above 2%, respectively.
In the UK and US, rate cuts are priced to occur soon after; in Europe, the jury is out on whether the ECB will reverse its interest rate rises over a five-year horizon.