The key news from the last week was the statement of several representatives of the US Federal Reserve, who said that the elevated inflation is very likely to plague the world's largest economy for longer than previously thought. Recall that in May, the year-on-year rise of the US consumer price index (CPI) was 5%, which was the highest value since 2008. However, US government bonds reacted only to a negligible extent to these statements by US central bankers.
The broadest global stock index MSCI All Country World recorded a gain of 2.3% last week. The main US stock index S&P 500 recorded a gain of 2.7% and closed the week at a new all-time high of 4281 points. The Central European stock index CECEEUR recorded a gain of 2.4%. Overall, global equity markets as a whole remain highly overvalued as our global valuation Z-Score reaches 2.4, which is still close to the all-time high. The average global equity valuation is thus currently around 2.4 standard deviations above the historical average, which is truly unprecedented. Therefore, I believe that equity returns will be rather below average in the next few years. The average annual equity returns, including dividends, over the next five years is unlikely to exceed 5%.
Bonds traded without major movements last week. The broadest global bond index, Bloomberg Barclays Global Aggregate Bond, did not change its value, while the average global bond yield to maturity rose by 0.02 percentage point to 1.15%. However, in real inflation-adjusted terms, the average global bond yield to maturity remains deeply negative, currently at -3.0%. Negative real inflation-adjusted bond yields to maturity are referred to as the financial repression. The performance of corporate bond indices was also around zero.
As for the outlook on bonds, they are just as expensive as equities at the moment, and even more expensive than stocks on the relative basis. Therefore, I believe that bond returns will be below average in the next few years compared to the average historical trends.
Commodities, on the other hand, did well last week. The global S&P GSCI commodity index strengthened by 1.9%. The price of the barrel of the North Sea Brent rose 3.6% to $ 76. Gold rose 0.5% to $ 1,777 an ounce.
US dollar weakened last week. DXY dollar index, which measures the dollar's performance against a basket of other major currencies, weakened by 0.4% last week. Against euro, dollar weakened by 0.6% to 1.194 USD/EUR. Koruna strengthened slightly last week. Against dollar, koruna strengthened 0.6% to 21.33 CZK/USD and against euro koruna strengthened slightly by 0.1% 25.49 CZK/EUR.
CHART OF THE WEEK – Very high valuations indicate below average expected annual equity returns in the mid-term horizon
Equity valuation indicators are currently at all-time highs. My proprietary valuation Z-Score is currently at the level of 2.4, which means that global stock market valuations are currently around 2.4 standard deviations above the long-term historical averages, which is truly unprecedented. Z-Score value is now even higher than during the technological bubble in 2000, when its value reached the level of 2.1.
Given that equity valuations have a strong historical tendency to return to long-term average neutral levels (mean-reversion) in the medium term, equity valuations are very likely to decline gradually from the current all-time highs in the coming years. If this baseline scenario of mine is actually fulfilled, the change in equity valuations – as the key component of total equity returns over the medium term – will contribute negatively to total equity returns in the coming years. For this reason, I believe that the average expected annual equity returns, including dividends, will be only around 5% in the next few years.
I admit that this equity outlook is not entirely favorable, however, it is unfortunately the reality of the current time, when share prices are at all-time highs, as well as equity valuations. Therefore, it is essential to focus on active investment management and try to look for undervalued assets while avoiding overvalued assets. Therefore, we are currently applying two key bets as part of our global equity allocation. First, we prefer emerging markets over developed markets, and second, we prefer value stocks over growth stocks. Both bets result from equity valuations, as both emerging markets and value stocks are significantly cheaper than their counterparts. Finally, in terms of the specific regional equity allocation, we prefer Central Europe and emerging Asia and, conversely, avoid US stocks, again due to significant differences in equity valuations.
Michal Stupavský
Investment Strategist at Conseq Investment Management, a.s.