Posts tagged ‘market valuation’

Linking Fortunes

Markets have begun to think about inflation again. In the US the new President is expected to contribute further towards existing pressure on prices; in Britain the weak pound has led to imported inflation as we saw again only this week. Talk in some quarters has turned, quite reasonably, to inflation protection, and specifically to index-linked bonds. This post is for anyone who is unsure what these are or how they work.

The UK was the first significant issuer of index-linked sovereign debt beginning in 1981. Details of the history and mechanics of the market are available from the Debt Management Office (DMO) website here. But the gist is as follows.

Gilts pay coupon interest semi-annually and repay principal on maturity. In an inflationary environment the real value of these interest and principal payments falls over time. So index-linked gilts, or “linkers”, have their coupon and principal varied in line with the Retail Price Index (RPI, the old measure of inflation, as distinct from the CPI measure which the Bank of England still officially targets).

Complicating things slightly there are two sorts of linker. The first, older variety lag RPI by eight months. This is to allow coupons to accrue on the basis of known values: a payment due in six month’s time will be based on the RPI print from two months ago (the additional month allowing for revision to the initial data release), so there is no uncertainty. Reflecting advances in technology, this type of gilt was superseded in 2005 by another which lags by only three months. This still allows for data revisions but by adjusting coupon and principal payments during accrual periods it follows RPI more closely over the life of the bond.

One further concept to mention is the breakeven inflation rate. This is the rate at which RPI would have to run to equalize returns between conventional and index-linked gilts of the same maturity. At present the benchmark ten-year linker yields -1.8% (these yields are always quoted in real terms). The ten-year conventional gilt yields 1.4%. So if RPI runs at 3.2% over the life of the bonds the linker will end up paying the same as the conventional. This tells investors about the relative value of the two types of security at different times, and about the market’s view on RPI inflation of course.

Index-linked gilts are the key securities for investors looking to protect themselves against UK inflation, as measured by the RPI. Of course in the event of RPI deflation then linker payments are cut rather than increased, which is something to bear in mind, as is the tax treatment: while gilt coupons are taxable as income any change in principal, including the full value of the indexation uplift, is completely tax free.

There are some index-linked corporate bonds in issue too. Like ordinary corporate bonds these pay a spread over government bonds to reflect credit risk and other things, but corporate linkers also track RPI in the same way as gilts. For individuals investing outside a tax wrapper, however, there is bad news. Unlike gilts, the principal uplift on corporate linkers is taxable – and taxable as income at that . . .

Of course the UK is not the only country to issue linkers. There is a sizeable French market, for instance. This offers bonds linked to two indices: the standard CPI and the CPI ex tobacco. Other eurozone countries also have index-linked government bonds in issue, which gives investors the opportunity to take views on respective inflation rates for different economies while bearing the same currency risk.

Some emerging market borrowers also issue linkers. Here, of course, currency volatility can be very high. But if inflation is imported on the back of currency weakness this benefits index-linked securities. In 2015 for instance the Brazilian real lost 49% of its value against the dollar. Year-on-year CPI peaked at 10.7%. And over the course of the year, the conventional government bond maturing in 2025 returned -8.1% while the 2024 linker returned 9.9%. For those interested in emerging market debt, then, there are times when indexation can be a helpful angle – where it is available of course.

Less exotically, the largest issuer of linkers is the US government by way of Treasury Inflation-Protected Securities (“TIPS”). The value of this market is currently $1.2trn (as against £603bn for index-linked gilts). TIPS seem to have found their strongest ever following at present. And not without reason: US breakevens from five years onwards are at about 2%, as against a 20-year average for CPI inflation of 2.2%. Should the US economy be entering a period of above average inflation, therefore, TIPS would offer value relative to conventional Treasuries – while giving dollar investors protection from the real-terms erosion of their wealth of course.

Index-linked securities are generally less volatile than conventionals, or thinking about this another way, even more boring. But there can be a place for dullness, or dependability, in portfolios. And in the event of a serious inflationary outbreak, linkers could well turn out to be the best bet in town. It is no coincidence that the British government first issued them on the back of a report from a committee that started work under Harold Wilson in 1977 – a short time after the oil crisis and a year over which UK inflation averaged 16%.

20/01/2017 at 6:39 pm

Shocks And Undercurrents

The ongoing drama over Greece continues to monopolise the financial world’s attention. We will probably find out how it ends – for the time being – in a day or two. In the meantime it has been easy to lose sight both of other potential sources of political risk and of the macro and market undercurrents which as rational investors we of course believe will come to dominate in the end.

Political risk is a difficult measure to quantify and a shock, by definition, cannot be planned for. However we have had some horrible reminders today that terrorism is grievously on the rise. This morning it was the attack on a factory in France; then a bombing in Tunisia; and a suicide attack on a Kuwaiti mosque during Friday prayers. These acts have all been claimed or inspired by the Islamic State.

The growing confidence and appeal of IS became glaringly obvious at the time of the Charlie Hebdo atrocity in Paris. Concerns have mounted since at the numbers of Muslims in European and other “western” countries who have tried to join IS in the Middle East, and who it is feared have been returning to shed blood in their homelands thereafter. And competition between IS and Al-Qaeda has been escalating in an attempt to establish leadership of global jihad. The rise of terrorism and the occurrence of any attack is lamentable but it is this last point which poses the risk to markets: something on the scale of the Bishopsgate bombing of 1993 or the 9/11 attacks eight years later has become a strategic goal for terror.

Meanwhile, the collapse of peace talks over Yemen last week has seen renewed Saudi bombardment of the country as the civil war there grinds on: the war doubles as a proxy conflict between the Saudis and Iran. Internal Yemeni rivalry between Al-Qaeda and the Islamic State is a complicating factor, as is the US drone campaign there against the former (though this is supposed to have been suspended in recent months). Elsewhere, negotiations continue to secure a commitment from Iran that she will not become a nuclear power; there is little encouragement to date that their objective will be achieved. In other words, the perpetual powder keg which is the Middle East has been getting even more alarming this year.

It seems reasonable to conclude that the risk of short-term setbacks to risk assets has increased in 2015. But what of the underlying fundamentals?

Here the picture is more mixed, which is to say, more positive overall. Attempts have been made to portray some of the major equity markets as dangerously overvalued but they do not stand up to balanced scrutiny. The economic outlook has disappointed in some places – most conspicuously in the US – and improved in others, such as in Europe, where even the threat of a Greek default has not noticeably dented confidence this month.

One area which has seen some movement this quarter has been the safe haven bond markets. There has been a marked sell off. The ten year gilt yield has risen by 60bp, the ten year US Treasury yield is almost 50bp higher and the ten year German bund yield is up by 70bp, having reached a low of 0.075% as recently as April. Upward moves in interest rates from the Federal Reserve, and with more of a local impact the Bank of England, have been drawing nearer for some time. The futures markets are currently pricing in a 25bp hike from both towards the end of the year. By then the disinflationary impact of last year’s fall in the price of crude oil will have unwound completely. Indeed, should the price rise between now and December then energy will become a source of inflation again.

Bond markets have a long way to go in many places, including here in the UK, before they start to close the valuation gap with equity. The earnings yield on the FTSE All Share Index is still almost three times the gross redemption yield on the ten year gilt, having averaged 1.8x over the last 20 years and 1.1x in the decade prior to the credit crunch in 2007. To reach those levels again the gilt yield would have to rise to 3.5% or 5.8% from 2.2% today. Furthermore, stock market observers seem pretty convinced that markets will take the early phase of rate hiking in their stride, largely because this is what happened last time. They might well be right – but this is not how things went the time before that (1994 as opposed to 2004) and since rate rises are such a novel idea these days their rediscovery surely poses some measure of risk.

So while the threat of short-term shocks has increased the possible medium-term headwinds from monetary tightening have been blowing closer too. It is doubtful whether most major stock markets are in bubble territory and likely that economic and reported earnings growth have much further to run. But selling on the records rather than buying on the dips appears the more rational approach at this point in time.

26/06/2015 at 4:59 pm

Breaking Records

There was some cheerful news for the UK equity market this week as the FTSE 100 index closed at a record high of 6949, finally beating the previous high – 6930 – it had reached way back on 30 December 1999. This milestone has generated a lot of comment on topics such as its relevance as an economic indicator and whether it comes as a sign that investors should sell. So what, if anything, does the record-breaking date of Tuesday 24 February 2015 tell us about the value of the market?

It has taken more than fifteen years for the 1999 record to be beaten. That is a good long time in financial markets, and perhaps especially so for markets in growth assets which have historically offered long run real returns of 5% per year. Had December 1999 been a textbook average starting point for investing in the UK stock market, then, and dividends from the FTSE 100 precisely matched the rate of inflation over the period we might have expected to see a price return of 1.05^15, or 108%. That would put the index on a level of 14407 rather than 6949 today.

When assessing markets, of course, we should not look at price alone. December 1999 was very far indeed from an average starting point. The price / earnings ratio for the FTSE 100 peaked that very month at 30.5x, de-rated sharply over the next couple of years and continued to descend more gradually, but very steadily, to lows (for the time) of around 12.2x in the summers of 2006 and 2007. This of course reflected the absolute reversal in sentiment from euphoria to depression associated with the collapse in the TMT / internet stock market phenomenon of the 1990s. During the Great Recession and its aftermath the p/e had a few bouts below 10x and has now bounced back to 16.6x, slightly above its twenty-year average level and somewhat lower than the 19.1x midpoint of its low-high range over that period.

Of course what this means is that the valuation picture is much more supportive of this new record price level than it was back when we last saw it at the end of the boom-boom 90s. This is even more the case when we flip the p/e ratio on its head (1/16.6 giving the conveniently round percentage of 6.0%) and compare this resulting earnings yield to a ten-year gilt yield of 1.8% and cash savings rates mostly below that. Back in December 1999 the earnings yield on the FTSE 100 was 3.3% as against 5.5% on the ten-year gilt and, by coincidence, a Bank of England base rate of 5.5% as well.

So breaking the 1999 record is not an obvious sell signal, and tells us at least as much about market sentiment and overvaluation back then as it does about those things today. On the other hand, given how close the current valuation metric is to its long(ish) run average, we should perhaps be expecting a total return of 5% plus inflation should 2015 turn out to be an equilibrium year for the UK market – but wouldn’t you just know it, we’ve had 5.8% of that already for the year to date. Still, a few months’ stagnation now is a small price to pay should that 5% real rate of return compound us forward for the next fourteen years from 2016 onwards. Again making the frivolous but convenient assumption that dividends match inflation, that would put the FTSE 100 on a price of 13758 come the end of 2029.

Perhaps worrying about price points at specific dates is not as useful a decision-making exercise as some others, then, especially when those dates are so very far apart. With the market at its current level it is obvious that it could move in either direction from today until the end of the year. Where it stood in 1999 is really not relevant. Before abandoning the notion of record stock market levels entirely, however, let’s briefly compare the positions of the other major developed-world blue-chip benchmarks.

In the red-in-tooth-and-claw corner stands the S&P 500, which has been consistently making new record highs since early 2013. (Its latest was 2115 on Tuesday, way ahead of the previous cycle peak of 1565 seen in 2007 and the dotcom era high of 1527.) In the very much bluer corner is the Nikkei 225, which rocketed up through Japan’s 1980s economic miracle to a high of 38915 on 29 December 1989. Today it closed at 18797, and will need to grow another 107% before it can eclipse that level, which could clearly take some time. Also looking rather glum is the Euro Stoxx 50, marked at 3572 at the time of writing down from prior peaks of 4557 in mid-2007 and 5464 in March 2000. (As an aside at this point, some of the British commentary on the new record has pointed to Germany’s DAX as an example of an index which has long eclipsed its 2000 peak. Unfortunately, however, the DAX is a total return index, meaning that dividend payments are rolled up in its value, giving it an unfair advantage against plain old cap-weighted price indices like the Footsie. The MSCI Germany index, by contrast, has beaten its 2007 peak but remains below its all-time high of March 2000.)

Again, the various record levels reached by these markets can tell us a lot about the start as well as the end points. The pitch of excitement – and in other parts of the developed world, awe – over 1980s Japan is well captured by that long-ago market pinnacle that will not likely be scaled again for many years. But it is instructive also to look at those peaks and troughs which are common to all these (huge and important) equity markets: highs across the board at the turn of the century, then again in 2007, and on the other hand the sharp falls in Q3 2011 … At times like these markets move in concert because they are thinking in concert – sometimes justifiably, sometimes not. The divergence between their performance over the last couple of years tells us that this is not happening yet. Again, there is good reason why this should be so when we consider differences in earnings, valuation, economic and sentimental factors between the different indices, but it should probably give us comfort too that the new closing record for the FTSE 100 is not part of some global rapture as it was fifteen years ago.

Apart from anything else, it never does any harm when an event like this comes along to provoke thinking and discussion. So well done to the UK stock market for beating its record, and let us enjoy sifting through the analysis before attention moves on.

27/02/2015 at 4:00 pm

Sterling Stuff

The British Isles have been living through some historically significant weeks. The Scottish referendum resulted in the continued existence of Great Britain as a nation, but only by a narrow margin. To say therefore that politics has been interesting here lately would be an understatement. But market behaviour, on the other hand, has not been terribly volatile. The stock market has remained completely range-bound. Gilt yields did reach new lows for the year to date in August, but there were never any signs of panic. In both cases prices have been moving in the same direction as other major markets.

Where there was some more eye-catching behaviour was in the currency.

Given the focus on the pound throughout much of the political campaign this is satisfyingly appropriate (and of course its international trading symbol clearly reads: “GBP”). The sharpest move against sterling came after a weekend poll published by the Sunday Times on 7 September showed a narrow lead for the Yes campaign. Monday saw the pound fall by 0.9% on a trade-weighted basis, its biggest one-day tumble for well over a year.

We should not get too carried away here: the euro has fallen further against the dollar since mid-year and shown almost equally great volatility this month, in no small measure due to the operations of the ECB. Still, the pound has experienced a material shift over the past twelve months and this begs the question: what is its fair value?

Trading ranges are one obvious place to look for guidance. Against the dollar, sterling almost fell to parity in 1985, and peaked at over $2 in 2007. The average cable rate for the past thirty years is parked in the middle of this range at $1.64. For almost exactly one half of that three-decade period, the pound has traded within ten cents either side of the average rate, which is remarkable. At its current price of $1.63, therefore, it looks fairly valued.

The euro rate is harder to pin down on this basis. From the launch of the single currency in 1999 to mid-2007 the pound held a range of €1.40-€1.70, broadly speaking; then it weakened dramatically towards parity in 2008 and has occupied a range of between about €1.05 and €1.30 ever since. At €1.28 currently sterling therefore looks a bit toppy on a purely post-crisis view, but a bargain relative to its pre-2008 levels. (The latter also applies if one charts the pound against the old European benchmark of the Deutschmark. If the DEM still existed a pound would buy 2.5 of them, below its averages over both the past twenty and thirty years.)

Fixating on ranges, however, is the proper preserve of traders, technical analysts and all those trying to make short term sense of the foreign exchange market (there but for the grace of God … ) The long run – and textbook – point of reference is the currency’s purchasing power parity. The theory behind PPP is that the same goods and services should cost similar amounts in different countries, assuming perfect freedom of trade between them. In practice, PPP valuations are therefore calculated by reference to the relative costs of similar items of consumption and to inflation rate differentials over time. OECD PPP estimates for the equilibrium sterling exchange rates against the dollar and the euro are $1.38 and €1.11, so the pound is actually looking expensive on this measure at the moment.

More interestingly, perhaps, are the implications of PPP for long term trading ranges. Using the OECD estimates, sterling is about 13% overvalued against the dollar. When it hit the same kind of levels about nine years ago the actual exchange rate was nudging $1.80. In other words, the somewhat higher rate of inflation in the UK relative to the US over that period has shifted the PPP valuation of the pound by about fifteen cents. Another way of looking at this is that the high reached recently of $1.72 is equivalent to $1.87 a few years ago.

Over the last three decades the UK and US economies have exhibited identical average rates of CPI inflation (2.8%), which is consistent with the stability of the cable rate’s trading range over the period. Turn to Europe, however, and the picture is rather different: over the last ten years, the annual rate of CPI inflation in the UK has on average been higher than that in the eurozone by 0.8% (2.7% as against 1.9%). Going back much further is problematic as zone-wide data is not available prior to 1997 and back in the 1980s there was the matter of the separation between East and West Germany. But the twenty year average rates of CPI inflation in France and Germany are 1.5%, compared with 2.2% here in Britain.

This means that the 14.5% undervaluation of the euro against sterling on the OECD measure pits the current rate of €1.28 against a rate of almost €1.60 when the same level of undervaluation could be observed in the autumn of 2002. So while the trading range of the currency alone might suggest that the pound is priced at a rather weak level against the euro, PPP tells us that we need to shift our assumptions to take account of the material inflation differential between the UK and Europe over the last ten to twenty years and perhaps adjust ourselves to something along the lines of the post-2008 range as the new normal.

Between the long-run PPP and the short term trading view of the world are a handful of other significant forces on the exchange rate. The desirability of UK assets, the attractiveness of the country as a place to do business, the development of views on the likely future path of interest rates and (joining all these dots together) the outlook for economic growth are hugely important considerations. But the impact of PPP, and inflation, is observably apparent.

On that basis it is not quite reasonable to interpret the recent fall in the value of the pound as a conspicuous buying opportunity. And when looking at the currency diversification of a portfolio on a medium to long term investment horizon, it is worth bearing in mind the stubborn tendency of the UK economy to inflate more quickly than its major market peers over the last decade or so, especially in the case of Europe, and to consider the possibility that this might persist.

26/09/2014 at 4:04 pm

The Bottom Line

One of the key themes this blog identified on the eve of 2014 was earnings growth. Equity valuations in the major markets had reached territory that needed to see a higher denominator in the p/e ratio or risk looking overvalued.

Since then we have seen a quarterly contraction in the US, patchy outcomes for GDP across the Eurozone and tax-related volatility in the Japanese economy. There has thus been reason to suspect that this growth would disappoint. And that is before considering any confidence impact from events in Ukraine, the Middle East and elsewhere.

So the Q2 US earnings season which opened in early July was arguably more important than most. When it opened, consensus expectations as followed by Bloomberg were for a 4.5% increase on the prior year, barely higher than the 4.2% increase in nominal GDP over the same period.

In early August, however, just as the S&P 500 had fallen back towards 1900, things were looking rather better. By this time the first 200 companies had reported their results. The increase in EPS was averaging 12%. The analyst consensus began to catch up, and the final outcome for Q2 was then expected to reach 8.2%.

Now the season is essentially over with 499 companies having reported. Index earnings for the S&P rose by 10.3% over the prior year. In price terms the 500 is up by more than 18% over the last 12 months, but supported by that bottom line growth the exuberance does not appear irrational – especially if most of the momentum can be maintained, as is expected.

There was an interesting story out this morning on European earnings growth too. With the sovereign debt crisis and the double dip recession, the outcomes for reported EPS on the Stoxx 50 have been dire. But for the first time since April 2012, there are now more positive than negative earnings revisions coming from analysts covering European stocks. In the words of one such:

“There are signs that the pressure on European companies … is beginning to abate. We’re beginning to see small upgrades in earnings estimates overall for the first time in absolutely ages.”

There is a connection here to recent euro weakness, and a further connection to the open mouth operations of the ECB. There is also a lot of ground to make up: simply stripping out reported losses reduces the historic p/e on the Stoxx to 16.1x from over 23x. For the S&P 500 this makes almost no difference – 18x drifts lower to 17.8x.

These markets are not a steal any more – in isolation, certainly. (Relative to bond markets they still look very cheap, but that says just as much about poor value in rates.) It has been a long wait for many to see real, underlying growth actually return to growth assets. What it needs to do now is continue.


12/09/2014 at 4:58 pm

Finding Some Direction

We are now comfortably over half way through 2014. After a shaky start, and despite persistent jitters, much of the year was actually quite undramatic for financial markets. For a while it looked as though asset prices were struggling to establish any direction. In some areas this has remained the case. But since the spring there have been signs of movement, and these have been mostly supportive of the pricing of risk.

Starting with assets which have prolonged their mundanity: gold, at just under $1,300 an ounce, is priced almost exactly in line with its average for the year to date. Despite some volatility over May and June it shows no sign of directional movement whatsoever. The story is the same for oil, which spiked up as news broke of the crisis in Iraq but has since fallen back again to about its average level for the year so far.

Government bonds have not been terribly exciting either, at least in general. The ten year gilt yield, for instance, has moved within a range of 2.5%-2.8% since mid-February and currently stands at 2.6%. On the other hand the ten year German bund yield hit a record low of 1.15% only this week, having tumbled from 1.94% at the end of 2013. In recent years this might be seen as a reaction to crisis fears in Europe, but this time round it would appear to have more to do with declining inflation and anticipation of the ECB’s policy response: bond spreads in the peripheral eurozone countries have, without exception, tightened over the year to date.

In fact, credit markets generally have been giving the strongest risk-on signals. High yield spreads, as measured by the Markit iTraxx Crossover index, narrowed with conviction as the year wore on. Twelve months ago they were above 4%. Now they are under 2.5% and have closed below 2.2% in the last few weeks. At that level they were almost exactly in line with the average for 2006 when the Great Recession was a mere glint in the US mortgage market’s eye. Consider also that only this month we saw a default event materialise in the banking sector of a south European country. Just imagine the effect this would have had on markets in late 2011 / early 2012. In this case spreads came off their lows but by no stretch of the imagination has there been any sign of real panic. The transformation is astounding.

Equity has found some tentative direction too. As late as mid-April, year to date returns for both the MSCI World Index of developed-world markets and the MSCI Emerging Markets Index stood at an unbeatably dull zero. But since then they have now risen to 7.3% and 9.4% respectively.

Past performance, as they so rightly say, is no guarantee of future returns. There are several “known unknowns” to contend with as the year continues. Political risk in the Middle East and Ukraine shows no sign of subsiding. Earnings growth, especially in Europe, needs to come through to support equity markets at current valuations. And the ancient phenomena of price inflation and monetary tightening could provide unsettling surprises as the quarters grind on.

While there is nothing to stop them being unwound, however, these signs of a rediscovery of market direction are cautiously encouraging. Looking forward the safest observation we might make is that the behavioural inconsistency in some asset prices should not be expected to persist indefinitely. Bears, as well as bulls, now have a little more scope to position themselves accordingly.

25/07/2014 at 4:04 pm

Signs Of Exuberance

The US shutdown is over. Japanese inflation for the year to September reached its highest level for nearly 5 years. And UK GDP data showed signs of a strengthening recovery. The S&P 500 has risen 4% since the beginning of the month, the FTSE 100 has done likewise and the Euro Stoxx 50 is up by a little more.

At the same time, the Norwegian sovereign wealth fund – the world’s largest with $810bn under management – announced that it is waiting for a correction before increasing its equity exposure. (See the widely-read Bloomberg story here.)

Developed-world equity markets have had a strong 2013, to the point where it is difficult to argue on some measures, such as p/e ratios, that they offer value. Are we entering the territory of over-exuberance?

As a starting point let’s have a look at what the CEO of that Norwegian fund actually said:

Our share in the stock market has been stable or falling even though markets are rising, and that means in practice that we’re not using inflows to buy stocks … In general, we see market corrections more as opportunities than as threats, so it’s not something that worries us. If they come, that’s just a positive sign for us as an investor.

According to the interview he did say the fund was “preparing for a correction”. But this is a fund whose rapid growth is underpinned by sizeable petrodollar inflows. They are not selling the market, and in the event of a correction – should it come – they intend to start buying again. In fact this sounds like the Norwegian central bank is offering the market a put!

In addition it is always worth looking at what reported earnings are doing. US news has been dominated by political and monetary goings-on, but the S&P is almost half way through the latest quarterly earnings season: 243 companies have reported an overall EPS increase of 8.4% on the previous year so far, significantly ahead of expectations. If that growth rate can be sustained as predicted the current price level would soon look much easier to bear.

Finally, the rally in risk pricing has not been universal. We took a look at India a few weeks back when the rupee was coming under heavy pressure for instance. Indeed, emerging market equity in general has underperformed its developed-world equivalent by a margin of 23% over the year to date. Selective exuberance may be irrational in some ways but it is not so terrifying as indiscriminate (and price insensitive) optimism.

The Norwegian view looks sensible: no panic, nor any excitement over the major markets at current valuation levels, and a preparedness to buy again should prices come down.

The markets which have performed the most strongly – as ever – may not be offering the most obvious opportunities. But the steady stream of positive data on earnings and economies is encouraging for their investors nonetheless.

25/10/2013 at 4:48 pm

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