Value Perspective Quarterly Letter – Q2 2021
Forgive us, dear readers, for this foray into the hot topic in markets today: Inflation.
What business do bottom-up, fundamental value investors have with inflation you might ask?
Well, we are certainly not going to offer a view on the future path of inflation, not least because the forecasting of macroeconomic variables is notoriously difficult. However, there is a view among some that value stocks stand to benefit from higher inflation, and we are going to explore that here.
Investing is akin to applied history, so let’s take a step back and start with the big picture. The debate around inflation and what it might mean for equities has to be viewed within the context of asset markets that, for the past 10 years have been dominated by declining inflation, falling interest rates and quantitative easing (QE).
Source: Société Generale, data to May 2020
With the help of these data and charts from Société Générale, we can see that even with low levels of inflation, at under 2%, the real yield on a traditional global balanced portfolio is already negative, which in turn means markets are particularly vulnerable to higher inflation today.
If we go further and split the global equity market into valuation quintiles based on the 5-year trailing correlation to US bonds, we can see that at around 2010/11, with the onset of QE, a gap begins to open up. Put simply, this gap is between stocks that benefited from the lower discount rate (quality and growth) and stocks that suffered (cyclicals, financials, value).
What these data show us is that valuations have become so extreme, in part due to ultra-low bond yields. It follows that investors seeking quality or growth in the equity market have significantly re-rated these stocks, which leaves them very vulnerable to higher yields.
For the past few years, weak inflation, disappointing GDP growth and falling bond yields led by QE have benefited growth/quality areas, and penalised the more economically-exposed cyclical areas, which at this point in the cycle, make up much of the value universe. This has pushed relative valuations to never-before-seen extremes. The green line is now at risk as it is very expensive, and it is highly negatively sensitive to rising bond yields. On the other hand, the blue line is cheap, and it is because of the macro regime of the last decade, so it stands to benefit most from it reversing.
This explains how we got here, but what can a longer-term history from multiple markets tell us about inflation and equity market returns?
It’s all about your “in” price
Now we’ll lean on some data from Citi, who have collated inflation and equity market data since the 1950s. This shows there is a relationship between inflation and equity market returns. Broadly speaking, equities have been a decent inflation hedge (see chart x). This makes sense: they are a real asset class, where corporate revenues offer positive exposure to rising consumer prices.
Source: Citi Research, Global Financial Data, MSCI, 7 June 2021.
But the relationship between inflation and equity market returns isn’t one you’d hang your hat on. Equity markets struggled in the 1970s when inflation was running away, and they performed poorly in Japan in the 1990s, and the US in the 2000s, even though inflation and interest rates were falling during these periods.
If inflation isn’t a reliable guide, then what? The right hand chart plots subsequent decade returns against those markets’ starting cyclically-adjusted price-to-earnings ratios (CAPEs). If we look for those same poorly performing periods for Japan in the ‘90s and the US in the ‘00s, we can see that Japan’s starting valuation was 80x and the US was 50x CAPE.
The conclusion here is there is a much better predictor of longer term equity performance than inflation, and it is starting valuation. While it is true that inflation matters to an extent – and it is likely that modest inflation would benefit many of the cyclical companies to which value investors are exposed today – valuation matters much more. Ultimately, you get the equity return that you pay for, whatever the level of inflation.
Markets are expensive, but market averages conceal a stellar opportunity
OK, so you get the return that you pay for, but in aggregate, equities are pretty expensive. The US market, which accounts for 65% of the global benchmark, is as expensive as it has ever been on a variety of valuation metrics. Exceptionally high valuations can only point to exceptionally low returns over the longer-term.
If what you pay matters, and equities are expensive, how can we be so excited about prospective returns for investors from today?
Because valuation dispersion within the market – the gap in fundamental valuation between the most highly rated shares and least highly rated – remains at extreme levels. On a global basis, the gap is more extreme than at the dotcom peak in 2000. Valuation dispersions mean that returns from the most undervalued parts of the market can be stellar over the coming years, even if overall market returns prove to be paltry. If the valuation gaps that we see today are to return to something more like normal in the context of long-term history, this value recovery has a long way to go.
The Value Perspective team
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.
This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.