Global equity indices near all-time highs
Antipodes Partners Limited
Don't be fooled by an Index
We've become accustomed to global equity indices marching in one direction - higher. The S&P 500 is sitting near yet another all-time high and valued at 21x forward earnings, with the index up 23% calendar year to date, you may assume it's been a great year for all US stocks.
As the index has moved higher only 50% of stocks are above their 200 day moving average. In fact, just five stocks - Microsoft, Alphabet, Apple, Nvidia and Tesla - account for 35% of the S&P's year to date return, and more than 50% of the S&P's return since April. The same five stocks account for over 70% of the NASDAQ's 18% return year to date.
Global equity indices are near all-time highs but fewer and fewer stocks are taking us higher. The market is crowding into an increasingly narrow subset of stocks - big cap tech. Reliance on the performance of a handful of names is not a backdrop conducive for markets to continue rising; it's typically associated with market draw downs, as shown below.
November's headline inflation print of 6.8% brings the 12 month rolling average to 4.2%. Assuming no adverse outcomes from Omicron (find our latest podcast discussion on Omicron here) and supply chain constraints are ultimately alleviated, there's a pipeline of inflationary pressures building via wages, rent and energy prices which can keep inflation above trend over 2022.
Wages in the US are rising 5% p.a., meaningfully higher than the historical average of 3% p.a, and the labour market is tightening. The number of Americans filing for unemployment benefits recently fell to the lowest level in 50 years and the US Federal Reserve (the Fed) forecasts the unemployment rate will fall to 3.5% by the end of next year, which is below the long-term average.
On the ground, the annual increase in asking rents has been running at more than 10% higher for the last few months versus the 3.8% yoy captured in the latest CPI report. This is thanks to the low-interest rate fuelled property boom in the US where house prices are accelerating at the fastest pace in 15 years, which feeds into rent with a lag.
And finally, energy prices remain elevated. European gas prices have been extremely volatile recently reaching $29/unit - a level around three times higher than prior peaks. Europe is facing a once in a multi-decade energy supply crunch. Larger than expected drawdown of inventories with no increase in supply in sight means that demand rationing will likely need to continue throughout the winter. Meanwhile in the US, the gas price has recently corrected by over 30% to under $4/unit on account of warmer weather which has driven down near-term residential demand. But this could easily reverse. Over the longer-term energy prices can remain structurally higher even with decarbonisation because hydrocarbons have seen supply rationed. Companies are investing below replacement cost levels.
Sticky inflation and a tighter labour market has seen the Fed scrap the use of "transitory" in relation to inflation and recently accelerated tapering to $30b per month, meaning the Fed will no longer be buying new issuances of Treasury debt after March 2022. While there's no explicit timing for rate hikes the market has priced in one rate hike by June 2022 and three hikes by the of the year taking the cash rate to 0.75%.
So, what does this mean for bond yields? As conditions tighten, coupled with a relatively resilient outlook for economic growth (even with the pace of growth slowing) is it reasonable for yields and discount rates - the rate used to value a company's future cash flows - to remain at historically low levels? As yields/discount rates have collapsed earnings multiples have risen. Higher yields will be a meaningful headwind to weaker companies that are valued at unsustainably high multiples.
In fact, this may already be playing out. The bottom quartile of the NASDAQ (based on 1 year performance) - arguably the weaker expressions of growth - is around 30% lower than its 1-year highs versus the NASDAQ index itself which is only 6% off its 1-year high.
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