Valuations begin to normalise

15 Feb 2017

Thanks to better forecasts for growth and inflation, the financial markets have gone through the first phase of normalisation. As a result, the wide range of valuations for equities and bonds has become narrower. High expectations and valuations mean more risks for equities in several regions.


Stabilising global growth as investment increases
Following a strong trend towards improvement that started in the summer of 2016, the worldwide purchasing managers’ index did not rise any further in January. The indicator for the business climate in the eurozone also stabilised in January, with a growth figure of 0.5 % here for the fourth quarter. Compared with other components of spending, investments performed fairly well worldwide. In Germany, orders for durable goods strongly increased, not only from foreign buyers: improved business confidence in Germany resulted in orders from German companies themselves.

Labour costs continue to fuel inflation in the US
The most visible general tendency in the American figures was one of slightly increasing inflation, supported by a trend of increased wages and labour costs. Inflation in the eurozone rose from 1.1 % in December to 1.8 % in January, fuelled largely by higher prices of oil and food on the global market. Other goods and services showed hardly any inflation. Core inflation in the eurozone remained stable at 0.9 %.

Investment categories

Bonds: European uncertainty leads to higher interest rates
The iBoxx Overall Index started the year with a 1.6 % drop. The German ten-year rate rose by 0.23 %, reaching 0.44 %. Government loans reacted quite strongly to the news of increasing inflation in the eurozone. Additionally, the ECB might reduce stimulus. Due to uncertainty over the French elections, interest rates in France rose by 0.35 %, which was stronger than rate increases in Germany. Throughout the course of the month, discussion reignited over the reforms in Greece. The IMF is threatening to pull out of the aid programme, while other eurozone countries are unwilling to relieve Greece of its debts. The interest rate on Greek ten-year bonds rose by 0.73 %. All in all, this resulted in a negative return of 2.1 % on government loans in euros. Corporate bonds fared better, with a limited loss of 0.6 % for the corresponding iBoxx Index.

Equities: Flat prices
Measured in euros, prices on the equity markets remained unchanged in January. In terms of regions, the best returns were found in emerging markets, but the differences were not very significant. On the sector level, there was a clear disconnect between the energy and  basic materials sectors, with the latter achieving a positive return of almost 5 % measured in euros and the former losing more than 5 %. The difference between the two sectors (which normally remain on track with one another) owes partly to differences in prices of raw materials. The first corporate figures for the fourth quarter exceeded expectations. Profit growth per share appears to be accelerating. Takeovers set the tone for the healthcare sector in January, while in the telecommunications sector, Verizon made a bid for Charter Communications.

Currencies: Mexican peso and Chinese yuan stronger, despite Trump’s threats
There was limited movement in exchange rates. In the second half of the month, the Mexican peso rose, compared to the American dollar, with no end to US President Trump’s harsh words towards America’s southern neighbour. The Chinese government’s increasing regulation of the country’s capital market caused the yuan to rise by 1 % compared to the US dollar in January, following an 11 % drop since the summer of 2015.

Economic forecasts

Less favourable long-term prospects
The global economy is heading into several quarters of historically average growth, which is relatively good in comparison with the period since the bank crisis. In the long term, the forecasts are less favourable in our opinion. Hopes of a stronger economy following Trump’s election will not entirely be fulfilled. There is no expectation of any extra impulse towards consumption at this late stage of the business cycle, partly because consumers are confronted with rising prices. A contribution from increasing investments offers more opportunities. There is great political uncertainty, with important elections coming up in various eurozone countries, and this will possibly lead to less international cooperation. Finally, fiscal stimulus will take the place of monetary stimulus policy, but to limited effect.

Asset allocation

US: Valuations for equities and government bonds even out
According to our investment principles, the investment categories’ returns depend heavily on valuations. Scientific studies show, for example, that a low dividend return is a better predictor of price gains than it is of dividend increases. The valuations of investment categories have changed dramatically in recent months due to major price fluctuations. In particular, the proportions in the US have been shaken up. According to our models, both categories are now equally valuated in the US due to equity prices rising at the same time as government bonds are decreasing in price. This has not happened since the beginning of 2007. In the eurozone, the rotation from bonds to equities is not as strong, with the latter category still showing greater long-term potential.

Greater risks for equities in the months ahead
In our mixed portfolios, we maintain an underweight position in bonds in comparison to liquidities. As interest rates rise, high valuations become a less important argument. Our position on bonds is based primarily on our economic perspective. In the months ahead, we expect inflation to continue rising and the ECB to become increasingly hesitant when it comes to economic stimulus. After half a year of positive economic developments, there is a mounting chance for disappointments. Moreover, equities valuations have continued to increase worldwide. Therefore, we are taking a neutral view of equities in our mixed portfolios as additionally equities valuations have continued to increase worldwide.