The Scales of Fundamentals and Price

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In weighing the value of any security, the scales of financial markets are supposed to maintain a fine balance between fundamentals and price.?The plate of fundamental factors is piled high with macro trends, geopolitical issues, weather and environmental events, policy decisions and individual security attributes.?The other plate is far more sparsely occupied – price stands alone, accounting for half of any assessment of the opportunity and risk in the purchase of an asset.?

Occasionally, the scales are tipped by the helium of investor optimism or the lead weight of investor despair.?But the half-life of these emotions is short and as they fade, the question for a long-term investor should always resolve itself into a judgment focused evenly on fundamentals and price.

Fundamental problems

This is a particularly important point to remember in a year which has contained so much fundamentally bad news.?The world is still struggling to shrug off the impacts of the pandemic as China, for now, sticks to a zero Covid policy.?Global commodity markets have been rocked by Russia’s brutal invasion of Ukraine which has simultaneously boosted inflation and threatened Europe with recession.?And many central banks, led by the Federal Reserve, have turned more hawkish, raising rates to levels not seen since before the Great Financial Crisis.?

These issues have, not surprisingly, led to sharp selloffs in both fixed income and equity markets.?However, for long-term investors, it is important to make a rational assessment of how long they?are likely to continue to negatively impact markets.

There is no doubt that the zero Covid policy has slowed growth in China, as have attempts to stabilize the housing market as well as some regulatory initiatives undertaken in 2021.?It is likely that the Chinese government will reassess some of its policies following the October Communist Party congress.?While this doesn’t assure a pivot towards more pro-growth policies, China’s long-term economic goals would suggest a necessity of finding a way to diminish obstacles to growth.

Russia’s war against Ukraine, apart from its horrendous humanitarian toll, has created economic hardship around the world and particularly in Europe.?This could well result in recessions in both the Eurozone and the UK.?However, it should be recognized that governments throughout the region are taking very aggressive action to protect families from the worst effects of the energy shortage and to source energy from elsewhere.?Moreover, while it is dangerous to speculate on the actions of any individual autocrat, President Putin’s actions have been so disastrous for Russia that we should not discount the possibility of some change in Russian policy or leadership in the year ahead.

That being said, the greatest challenge for U.S. investors this year has come from the much more hawkish stance of the Federal Reserve.?Last week’s FOMC meeting continued this trend with a 75-basis point hike in the federal funds rate, a higher projected path for interest rates in the Summary of Economic Projections and very hawkish language in both the FOMC statement and in Chairman Powell’s press conference.?In particular, Chairman Powell made it clear that the Fed would be willing to tip the economy into recession if that was what was required to get inflation to its 2% objective.

This does have the appearance of a policy error.?Despite a current focus on the evils of inflation, there are good reasons to believe that inflation will fade on its own as commodity prices retreat, the global economy softens and the excess demand of the pandemic years fades in the face of a higher dollar, a housing slump and much diminished federal deficits.?It may well be that the Fed has to reverse policy in 2023 as recession replaces inflation as the economy’s number one problem.

The opportunity in lower prices

The challenges to financial markets posed by actions in Beijing, Moscow and Washington are of course all very different and no-one should equate the choices made by a monster such as Putin with the well-intentioned, although arguably misguided, actions of the Federal Reserve.?However, these policies all have one thing in common.?They are all, to some extent, reversible and the global economy can in time recover from choices made in 2022.

Meanwhile, long-term investors should pay ever closer attention to how these choices have impacted asset prices.

• At the end of last year, the 10-year Treasury bond was yielding just 1.52%, offering investors neither income nor any real protection in the event of a stock market selloff.?Today, with a yield of 3.68%, it offers both.?Moreover, across fixed income markets investors can find much better opportunities with TIP yields turning positive and yields more than doubling since the start of the year across investment grade corporate bonds, high-yield bonds, municipals and mortgage-backed securities.
• At the end of last year, the forward P/E ratio on the S&P500 was 20.9 times, 24% above its 25-year average of 16.9 times.?As of Friday, it was at 15.6 times, 8% below that long-term average.?Moreover, within equities, non-mega cap stocks and value stocks are at a steeper discount to their long-term averages.
• ?At the end of last year, the forward P/E ratio on the MSCI-ACWI ex U.S. was 14.3 times.??Today it is 10.9 times.?This valuation is not only low in absolute terms but it is also very low relative to U.S. equities.?It should also be seen in the context of a dollar exchange rate which has risen by an extraordinary 17.8% so far this year to its highest level in real terms since the mid-1980s.

For many investors, there is, of course, plenty of pain embedded in today’s cheaper valuations.?However, bull markets always start in the basement of investor despair.?

There are plenty of things that could go wrong in the next year.?However, there are also plenty of things that could go right.?

If, over the next year, China transitions to a post-Covid economy, some ceasefire or settlement is reached in Ukraine and the Fed pivots to a less hawkish stance, financial markets could be expected to react positively.?Bonds bought today could benefit from lower Treasury rates and tighter credit spreads.?U.S. equities could rebound as uncertainty diminished and the economy transitioned to a slow-growth, low-inflation environment.?And investments in international equities could benefit from both better local currency returns and a retreat in the dollar from its current super-high levels.

Some of these events could, of course, take longer to play out and the global economy will undoubtedly face new challenges.?However, perhaps the most important thing for investors to consider at the start of the fourth quarter is that, while at the start of the year most major asset classes were priced for perfection, today many have been discounted for disaster. ?

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