26 Oct Monthly Commentary: October 2020
Key global trends – equities finally pull back
Global equities had their first monthly negative return since bottoming in March, reflecting a shakeout in the high-flying U.S. technology sector. Despite the risk-off equity sentiment, gold prices also fell back (and commodities more generally), which likely reflected a rebound in the ‘safe-haven’ $US. Already very low global bond yields hardly budged either way.
Despite these ‘counter-trend’ moves in September, as seen in the chart set below, global bond yields and the $US remain in a medium-term downtrend, with global equities and gold prices in an uptrend*.
Global equity fundamentals – valuations reliant on low bond yields, earnings expectations have lifted
Let me offer a couple of new charts this month – breaking down the key fundamental drivers of the most important equity index in the world, the S&P 500.
As seen in the first chart below, the S&P 500 ended September trading at a price-to-forward earnings (PE) ratio of of 21.3 – which is a bit lower than the levels seen in recent months, due to both the correction in prices and a modest lift in forward earnings. As evident, 21.3 is well above its long-run average level but to an extent reflective of the very low level of bond yields – with the U.S. 10-year government bond yield ending the month at only 0.7%.
Econometrically drawing a ‘line of best fit’ through the monthly levels of interest and PE valuations stretching back several decades (granted a crude valuation metric), suggests a PE ‘fair value’ at end-September of 19.9, or 7% below the actual level. Given the loose relationship evident in the chart, however, this degree of valuation is not that extreme – and somewhat less stretched than at end-August.
My second chart focuses on U.S. earnings expectations. It tracks analyst expectations for calendar year earnings and hence forward earnings estimates on a rolling monthly basis.
Note: ‘forward earnings’ is a weighted average of current and subsequent calendar year estimates – with the weight on next year’s earnings rising as it gets closer. In essence, for example, forward earnings in June 2020 reflect a weight of 50% to CY’20 and CY’21 earnings respectively. In December this year, forward earnings will place a 100% weight on CY’21 earnings (wherever analyst expectations are at the time).
The chart below shows that while earnings expectations were downgraded significantly earlier this year (reflecting the economic lockdowns) they have since stabilised, and in fact increased a little. Based on current market expectations, U.S. forward earnings are on track to rise by 23% between now and end-2021, which (at end-September prices) would pull down the PE ratio to a more reasonable 17.3. Even allowing for moderate further downgrades (my estimates in the table below) could still see forward earnings rise by 14% over this period, with the market trading at an end-2021 PE ratio of 18.7.
All up, this analysis suggests the U.S. market could hold up if the economic recovery continues and bond yields stay reasonably low – but significant further upside could be limited, given the prospect of some eventual lift in bond yields and an already fully valued market.
Key global equity themes – U.S., technology, growth and quality
As seen in the table below, it was the popular U.S., technology and growth/momentum themes that suffered the biggest pullbacks in September, though financial, energy and ‘value’ stocks more broadly also had notable declines. Being only the first month of a potential ‘counter-trend’ equity rotation, the relative performance rankings of the long popular U.S., technology and growth/momentum themes remain in place.
Tables ordered by 6/12 month return performance for each region, sector and factor respectively – on a local currency basis. Past performance is not indicative of future performance. You cannot invest directly in an index.
Cash and bonds – government yields drop, credit spreads widen
In the local cash and fixed income market, overall bond yields fell last month while credit spreads widened – resulting in fixed-rate bonds outperforming cash, and government bonds doing better than corporate bonds (of similar duration).
Source: Bloomberg. Past performance is not indicative of future performance. You cannot invest directly in an index.
This was produced by David Bassanese from BetaShares you can read the full article here.
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