On the one hand, most economies are still in the midst of reopening following intermittent lockdowns in 2021. GDP growth forecasts for this year and next are above long-run trend rates. Earnings growth forecasts are consequently solid at around 10% in 2022 year-on-year for the larger markets.
On the other hand, the list of challenges facing the markets is rather long. Major central banks are embarking on tightening monetary policy, with the US Federal Reserve (the Fed) moving particularly aggressively after having waited too long to react. The war in Ukraine could yet escalate and in the meantime is keeping investors’ nerves on edge. The latest resurgence in Covid infections in China, and the consequent re-imposition of lockdowns, has already had a noticeable effect on Chinese growth (see Exhibit 1).
US 10-year Treasury yields have recently jumped sharply following comments from Federal Reserve Governor Lael Brainard that the Federal Open Market Committee would begin reducing the balance sheet “at a rapid pace – as soon as our May meeting.” This comment refocused the attention of investors on the Fed’s moves – in particular, the impact of quantitative tightening on real yields and (growth) stock valuations. It is not coincidental that the decline of the Nasdaq 100 index that day was almost twice that of the S&P 500.
The market’s reaction was similar to what happened in January this year, when swiftly rising expectations for the future level of policy rates led to an equally swift derating of US equities. Notably, however, once the rerating had occurred, the focus returned to earnings growth. As the results from the Q4 2021 earnings season came in, equities rebounded (see Exhibit 2).
Equity markets would likely have continued appreciating had the Ukraine war not started. A typical risk-off period ensued through mid-March, with real yields and equities falling on growth worries. But as the worst predictions of how the war might evolve did not materialise, and crucially, oil and gas continued to flow from Russia to Europe, a relief rally ensued.
Real yields are now back to where they were prior to the start of the war, so arguably the ‘relief rally’ has run its course. Expectations for the level of the fed funds rate in two years, however, are about 80 basis points higher. As real yields reflect more fully this change in policy rate expectations, we may see repeated episodes of markets advancing on the earnings outlook (two steps forward), but then falling on jumps in discount rates (one step back).
Despite the challenges posed by the pandemic to China’s economy, we have increased our allocation to Chinese equities. The authorities are very aware of the economic impact of their policies but they have committed to providing additional fiscal and monetary policy support to compensate for the drag on growth. It is worth recalling that the Chinese leadership recently committed to a 5.5% growth rate in GDP this year, and in general, what the Chinese governments wants, the Chinese government gets.
Equity markets, however, have been more sceptical. Since the beginning of 2021, Chinese equities have underperformed developed market equities by more than 40%. In fact, China accounts for the bulk of the underperformance of the broader emerging markets equity index. These lagging returns are not only due to the pandemic battle; they are also a function of significant changes in regulations, notably those affecting technology sector companies.
The significant underperformance has, in our view, now become an opportunity. Relative to the developed market MSCI World index, the forward price-earnings ratio of MSCI China is one standard deviation below the average since 2008. Importantly, though, this discount is driven mostly by the broad technology sector (include internet retail, movies & entertainment, and interactive media).
The broad index has been cheaper in the past (for example from 2013-2015), but the discount then was due mostly to the financial sector; technology was expensive. Buying the index today to take advantage of lower valuations is thus a very different prospect than it was the last time around.