Jim Solloway, Chief Market Strategist and Senior Portfolio Manager in SEI’s Portfolio Strategies Group, answers questions from Heather Corkery, Managing Director of Client Portfolio Management, in a two-part video series on the economic and investment outlook.
Enjoy part two
Heather: Hi, I’m Heather Corkery, Managing Director of Client Portfolio Management at SEI. We’re back with Jim Solloway, our Chief Market Strategist and Senior Portfolio Manager, to discuss what the evolving economic landscape means for investors.
Jim, we previously spoke about the prospect of lingering inflation and the likelihood that the Fed may need to hike interest rates higher and faster over the next few years than currently projected. How would you urge investors to think about the impact of rising rates?
Broad equity price movements have become increasingly tied to changes in benchmark interest rates. It’s an important relationship to understand, especially if we are reaching the end of the multi-decade bull market in bonds.
Equities on a global basis are now tied to what happens in the U.S. bond market. To highlight it, we focused on the valuations of developed-market stocks outside of the U.S. based on their correlations with the 10-year U.S. Treasury bond. This chart shows the forward price-to-earnings ratio for the 20% of stocks that are most and least correlated to U.S. Treasury bond returns.
The 20% of the non-U.S. developed stock market with the highest correlation to Treasury returns now sports a forward PE that trades at a 70% premium to the PE of the overall U.S. market. The bottom 20% of non-U.S. developed stocks, on the other hand, trades at a 40% discount. This dispersion in valuation is extreme and highlights how big a driver the U.S. bond market has become for those stocks that have performed the best over the past decade.
We also found it helpful to see a side-by-side comparison of the most recent valuations on a country-by-country basis.
The U.S. stock market is not much different from the rest of the major markets when it comes to relative performance and extreme valuations. The bottom line is that investors appear convinced that interest rates will remain at rock-bottom levels for a long time to come.
But if bond yields push higher over time, the cohort of stocks most correlated with bonds could face a de-rating of their earnings multiples despite their solid company fundamentals.
Heather: We’ve been hearing a lot about the duration, or interest rate risk, embedded in expensive stocks. This really helps connect the dots between the two, and also showcases the relative opportunity in less-expensive stocks.
At a high level, how do you see the investment landscape shaping up over the next year or two?
Jim: We think there’s a lot to be optimistic about. The U.S. has been leading the way, but other advanced countries, notably in Europe, continue to post improvement in economic activity. The earnings of publicly traded companies remain robust and we believe that analysts might still be underestimating that strength.
We looked at the earnings growth rates of select countries and regions for 2020 alongside consensus estimates for the current calendar year and 2022.
With the exception of Japan, all earnings estimates for 2021 have been raised dramatically versus just six months ago. Forecasts for 2022 earnings have been cut in half from where they were six months ago, but they still are expected to show mid-to-high single-digit gains.
This lowering of the bar for next year could allow for upward revisions in analysts’ earnings estimates, assuming, as we do, that global economic growth gets back on track as vaccines are more widely distributed across the globe and the Delta variant fades into the background.
This doesn’t mean that markets will move upward in a straight line. We’ve already experienced a rise in market volatility in recent weeks. The energy situation in Europe is worrisome and could hurt consumer spending power. We also are tracking whether companies can maintain their ability to pass along higher costs to their customers. That said, we don’t see a global recession on the horizon, so any price correction in equity markets should be of limited scope and duration.
Heather: Thanks, Jim, for sharing these insights.
Jim: Thank you for the opportunity to talk to our clients.
Glossary of financial terms
- Bull market refers to a market environment in which prices are generally rising (or are expected to do so) and investor confidence is high.
- Congressional Budget Office (CBO) is a federal agency within the legislative branch of the U.S. government that provides budget and economic information to the Congress.
- Cyclical stocks or sectors are those whose performance is closely tied to the economic environment and business cycle. Managers with a pro-cyclical market view tend to favor stocks that are more sensitive to movements in the broad market and therefore tend to have more volatile performance.
- Discount rate is the minimum interest rate set by the Federal Reserve for lending to other banks.
- European Union (EU) is a group of 27 countries that operates as a cohesive economic and political block. Nineteen of the countries use the euro as their official currency.
- Growth stocks exhibit steady earnings growth above that of the broader market.
- High-yield bonds are rated below investment grade and are considered to be riskier.
- International Monetary Fund (IMF) promotes international financial stability and monetary cooperation. It also facilitates international trade, promotes employment and sustainable economic growth, and helps to reduce global poverty. The IMF is governed by and accountable to its 190 member countries.
- Issuance is the sale of securities, typically with regard to debt instruments such as bills, notes and bonds.
- The Personal Consumption Expenditures Price Index
- Price-Pressures Measure (PPM) was developed by the Federal Reserve Bank of St. Louis to measure the probability that the expected personal-consumption expenditures price index inflation rate (12-month percent changes) over the next 12 months will exceed 2.5%. It is composed of 104 separate data series grouped into nine different buckets: (1) consumer-price indexes, (2) producer-price indexes, (3) commodity prices, (4) housing and commercial property prices, (5) labor-market indicators, (6) financial variables, (7) inflation expectations, (8) business and consumer survey data, (9) foreign price variables
- The Forward price-to-earnings (P/E) ratio is the ratio for valuing a company that measures its current share price relative to its forecasted earnings per-share (EPS) over the next 12 months.
- Yield is a general term for the expected return, in percentage or basis points (one basis point is 0.01%), of a fixed-income investment.
- Yield curves represent differences in yields across a range of maturities of bonds of the same issuer or credit rating (likelihood of default). A steeper yield curve represents a greater difference between the yields. A flatter curve indicates that yields are closer together.
- Value stocks are those that are considered to be cheap and are trading for less than they are worth.
The Chicago Board Options Exchange (CBOE) Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatility of the S&P 500 Index. Investors use the CBOE Volatility Index to measure the level of risk, fear, or stress in the market.
The Citigroup Economic Surprise Index measures data surprises relative to market expectations. The index was designed for currency trading, and its signals may not be relevant to other financial instruments. A positive (negative) reading means that data releases in the prior three months have been stronger (weaker) than expected.
The Citigroup Inflation Surprise Index measures the level of actual inflation compared with inflation expectations.
The Consumer Confidence Index is an economic indicator published by The Conference Board to measure consumer confidence, defined as the degree of optimism on the state of the U.S. economy that consumers are expressing through their activities of savings and spending.
The Consumer Price Index measures changes in the price level of a weighted-average market basket of consumer goods and services purchased by households. A consumer price index is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.
The Consumer Sentiment Index is a monthly survey of consumer confidence levels in the U.S. conducted by the University of Michigan. Consumer sentiment is a statistical measurement of the overall health of the economy as determined by consumer opinion.
The Harmonized Index of Consumer Prices (HICP) measures the changes over time in the prices of consumer goods and services acquired by households, and is an indicator of inflation and price stability. It gives a comparable measure of inflation as it is calculated according to harmonized definitions.
The ICE BofA Emerging Markets Corporate Plus Index tracks the performance of U.S. dollar and euro-denominated emerging-market non-sovereign debt publicly issued within the major domestic and eurobond markets.
The MSCI China Index captures large- and mid-cap representation across China H shares, B shares, Red chips, P chips and foreign listings such as ADRs. With 469 constituents, the Index covers about 85% of this China equity universe. Currently, the Index also includes large-cap A shares represented at 5% of their free float-adjusted market capitalization.
The MSCI Emerging Markets Asia Index is designed to measure the performance of the large- and mid-cap segments across nine emerging-market countries in Asia.
The MSCI Emerging Markets Index is a free float-adjusted market-capitalization-weighted index designed to measure the performance of global emerging-market equities.
The MSCI USA Index measures the performance of the large- and mid-cap segments of the U.S. market.
The MSCI World Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets.
The MSCI World ex USA Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets, excluding the U.S.
The Personal Consumption Expenditures (PCE) Price Index is the primary inflation index used by the Federal Reserve when making monetary-policy decisions.
The Purchasing Managers' Index (PMI) is an indicator of economic health for manufacturing and service sectors. Its purpose is to provide information about current business conditions to company decision makers, analysts and purchasing managers.
The PMI Manufacturing Index is a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It is considered a key indicator of the state of the U.S. economy.
The PMI Services Index is based on monthly questionnaire surveys collected from over 400 U.S. companies that provide a leading indication of what is happening in the private sector services economy.
The S&P 500 Index is an unmanaged, market-weighted index that consists of 500 of the largest publicly traded U.S. companies and is considered representative of the broad U.S. stock market.
The S&P 500 Value Index measures U.S. value stocks using three factors: the ratios of book value, earnings, and sales to price.
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