By Ryk de Klerk
GLOBAL financial markets’ behaviour was truly remarkable after Mr Market flipped the switch to risk-on in the last week of October last year on the back of the Biden/Harris victory in the US and the apparent successful development of a Covid-19 vaccine. Is Mr Market’s reaction too good to be true?
What we saw over the past 10 weeks is what normally happens in the full early stage of a global economic recovery.
Since October, emerging market equities as measured by the MSCI Emerging Market Index surged more than 15 percent in terms of US dollars, and developed market equities, as measured by the MSCI World Index, surged more than 19 percent. The FTSE/JSE All Share Index is up more than 30 percent over the same period, while The Economist Metals Index has surged more than 59 percent.
The valuation of developed market equities based on Robert Shiller’s PE10 metric is now at highs last seen before the 2008/09 global financial crisis.
Emerging market equities have surpassed the 2007 highs prior to the 2008/09 global financial crisis, developed market equities are now nearly 14 percent higher than the highs before the Covid-19 crisis, the Economist Metals Index surpassed the double tops of 2007 and 2011. Even the JSE is within reach of pre and post highs of the 2008/09 global financial crisis.My emerging market currency index compared to the US dollar recovered to its median since 2015, while the rand is slightly below its average against the US dollar over the same period.
I compared the calculated PE10 for the MSCI World Index in US dollar with my estimated average industrial capacity utilisation of the US, China, Japan and the euro area. After the Dotcom bust, 911 event and Enron scandal at the turn of the century, the PE10, or market valuation, of developed market equities tended to track the average capacity utilisation.
It is, however, evident that over the past three quarters the market valuation diverted significantly from the average capacity utilisation of the major economic countries and zones. In the aftermath of the global financial crisis it took seven quarters from the trough for the global economy to reach full capacity or 80 percent capacity utilisation.
If the same trend occurs in the current cycle, it means that the global economy will only reach full capacity by the end of the first quarter next year. A return to full capacity implies expansion of 7 percent in global industrial output over the next four quarters. But, in light of the severity of the impact of Covid-19 on global employment, full capacity will probably only be achieved by late next year or even deferred to 2023, depending on the successful rollout of vaccines.
The buzz words among investment strategists all over the globe are reflation, reopening and repositioning. I have not seen the bullishness on global equity markets, especially emerging markets, for a long time. I am not disputing the fact that valuations can overshoot on the upside – yes, exuberance could and will always happen.
What concerns me is that it seems that global equity markets are priced for perfection and are therefore vulnerable to any bad news.
Inflation is already raising its ugly head and can surprise on the upside. Commodity prices are already high and are likely to increase further as the major economic zones open up.
Above-ground stocks of metals such as copper are already teetering at lows last seen in 2006. Oil prices recovered to the pre-Covid-19 crisis levels and could lead to inflation overshooting the US Federal Reserve’s target of 2 percent.
It is already being priced in by investors in the US bond market. The 10-year break-even rate (a measure of average inflation over the next 10 years), calculated by adding the 10-year Treasury Inflation Protected Securities (Tips) yield to 10-year government bond yield, on Friday amounted to 2.14 percent.
The yield on a Tips bond is equal to the same term US government bond yield minus the expected inflation rate. The Tips yield will fall into negative territory if the government bond yield trades below the expected inflation rate.
The gold price in terms of US dollar is highly correlated to the 10-year Tips yield. As such, the gold price is also highly correlated to the inflation-linked bond indexes and tracker funds such as the iShares Tips Bond ETF. Gold can therefore be classified as a hybrid Tips with a constant maturity of 10 years.
Gold has severely underperformed global equity markets since the end of October last year and lost 1.5 percent in terms of the US dollar.
The massive stimulus envisaged by the incoming Biden administration inter alia encompasses quantitative easing by purchases of US government bonds. It would put a lid on US government bond yields. In December 2009, after the global financial crisis, the 10-year break-even rate peaked at 2.5 percent.
With risk-on assets priced to perfection, gold’s severe underperformance is about to end soon. It is time to protect against unpleasant surprises.
Ryk de Klerk is analyst at large. Email [email protected]. His views expressed above are his own
BUSINESS REPORT