Like other market participants, we expect inflation to remain low and the world economy to continue ...
Like other market participants, we expect inflation to remain low and the world economy to continue to recover in the coming months.
Although we are below consensus on US growth, our 2.25% forecast for this year still represents a perfectly reasonable rate of expansion.
Importantly, this combination of growth and inflation will allow interest rates to remain low: for example, our estimate of US short-term interest rates of 2.25% at year-end represents a very low level of real (after inflation) rates and an exceptionally low level in nominal (headline) terms. The economic backdrop in the UK and Europe is also positive.
Given this constructive economic backdrop, we are intrigued by the recent weakness in western equities. Nothing in the economic data has warranted such a widespread sale, while the geopolitical backdrop, though still far from ideal, has not worsened. If economics is not behind the recent falls in equities, could it be bond yields? It seems not, as yields have fallen with equity markets.
Therefore, it appears that uncertainty and fear of the unknown have hit equities: in technical terms, the equity risk premium has risen.
This situation is highlighted in the US. Here, valuations are still expensive but, at least as importantly, ongoing uncertainty over the actual level of core earnings for US companies means that, on earnings-based measures, the US is possibly even more expensive than it appears.
It is widely accepted that stock options expense should be included in core earnings, but other items are more contentious.
Discussions are likely to continue for the next 12 months. In the meantime, the increased uncertainty leads investors to demand higher returns before investing in US equities, resulting in a higher equity risk premium, reduced fund flows into the US and a weaker dollar.
In contrast, the UK and Europe are much less affected by the debate over core earnings. They are now looking attractive on all valuation measures relative to their 10-year history and, with nothing having changed fundamentally, these markets offer good long-term buying opportunities at current levels. Another uncertainty is the outlook for the dollar.
Our forecast is that it will continue to weaken in the coming months, albeit not dramatically, and that the impact on markets will be felt more in terms of fund flows than any translation effect on earnings. Therefore the biggest losers should be those areas that benefited the most from the inflows to the US of the late 90s ' the already beleaguered US mega-cap stocks and US corporate bonds are examples.
External factors such as geopolitics will play a part in determining the bond markets' short-term direction from here, with the UK's possible entry into the euro providing an additional distraction for gilts.
Our feeling, however, is that western bonds may have gone too far too fast, even if yields are reasonably attractive around current levels on a medium-term view.
Inflation and interest rates to remain low.
Equity valuations have fallen.
Real bond yields are not unattractive.
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