Jeroen Blokland

The global economy is cooling significantly and a large number of countries are at risk of recession. Equity valuations have fallen sharply in recent months, but do not yet reflect a drop in profits. And that is exactly what is in store.

Even before the European Central Bank has ended the current buying programme, ECB members are already working on a possible next programme. If you are still wondering whether the ECB’s policy might look different now that inflation is at record levels, you now have your answer.

When it comes to equity valuations, most investors are concerned with the price/earnings ratio. And while that P/E ratio has fallen to just below the average of the past decade, the picture painted by another valuation measure is much less attractive.

The decision is made. The ECB will also raise interest rates now that inflation is showing few signs of cooling. But this also increases the risk of a classic policy mistake.

Spreads on both corporate and high yield bonds have increased significantly in recent weeks. Nevertheless, especially the spreads on high yield bonds remain too low. Let’s get under the bonnet to explain why this is the case.

As the chart below indicates, corporate and high yield spreads are highly correlated. However, in recent weeks the spread combinations of both asset classes have been in the orange oval, indicating that high yield bonds are on the low side, compared to what you might expect based on history. The last data point is the pink square.

For years, US technology stocks have beaten the rest of the market. And not by much. This trend was reinforced by the Covid crisis, which pushed the valuation of growth stocks to unprecedented heights - even higher than during the ‘dot.com’ bubble. 

This sky-high valuation was sustainable as long as the earnings growth of these US growth stocks remained superior. But at least in the short term, this seems to be coming to an end. And that is not just because of the disappointing figures from Amazon.

Mortgage rates and home prices are skyrocketing worldwide. That is not good news for housing affordability.

The graph below shows the relationship between the one-year change in US 30-year mortgage rates and the one-year change in the ‘Housing Affordability Index’. Roughly speaking, the change in mortgage rates explains about 40 percent of the change in the affordability of a home for sale in the United States. 

The latest edition of the Bank of America Global Fund Manager Survey shows that fund managers are still overweight equities while their expectations of future economic growth have fallen sharply.

In fact, the chart below shows that fund managers have never been so pessimistic about growth. Not during Covid and not during the Financial Crisis. The mismatch between expectations and positioning is extreme.

Bond yields have shot up worldwide. The US 10-year yield stands at 2.90 percent compared to 1.50 percent at the beginning of the year. This has led not only to one of the biggest falls in bond prices ever, but also to a less attractive valuation of equities.

Most research papers on inflation focus on the period from 1950, after World War II, or from the 1980s after former Fed Chairman Paul Volcker destroyed inflation with a mighty series of interest rate hikes.