The wonderland of equities

Have equities lost their connection to reality?

You always have to be careful when you go against the market consensus because markets are pretty efficient after all. But equities do seem out of touch with reality with European equities down only 2.3% from the close before Russia’s invasion of Ukraine and Brent crude has given up most of its gains since the war started. The only rational explanation for this pricing is that the market is increasingly betting on Russia’s stalling military campaign will lead to a quick peace. That logic has been vindicated today with an official announcement from Kremlin that a neutral Ukraine with their own army is a possible compromise. While this is a positive step things could still change and one would also think that part of any deal is Russia seeking Europe to roll back sanction under some reasonable timespan.

But even if we get peace in Ukraine the sanctions on Russia will maintain for some time and the ripple effects in commodity markets will continue to endure. In addition, the constraints on the supply side of our economy will continue to haunt companies through inflation. Investors need to remind themselves of what the fundamental drivers of equity valuation are:

1. Revenue growth
2. EBITA margin
3. Incremental investments
4. Discount rate

Of these four factors only revenue growth is trending positive for equity valuations as the massive fiscal stimulus is creating both inflation and higher nominal growth. However, inflationary pressures, disruptions in the global supply chain, wage pressure, and high commodity volatility are creating headwinds for operating margins which have declined in the previous quarter and no week goes by without more and more companies lowering their outlook for margins; today both BMW and Fevertree were out with a lower operating margin outlook. As the global economy is constrained on the supply side due to a decade of underinvestment and companies are shoring back production in from Asia in a response to the fallout from the pandemic, the incremental investment need will go massively over the coming decade. Yesterday, Intel announced the first plans for its €80bn investment plan over the next 10 years in Europe covering R&D facilities, manufacturing and foundry services. Finally, the discount rate is moving higher with the US 10-year yield hitting almost 2.2% and central banks in an inflation fighting mode suggesting that financial conditions will tighten.

Overall, the vector is negative for equity valuations which still remain at the 87% percentile measured over the period 1995-2022 (see chart). In our view equities will go to its average historical valuation reflecting inflation and the disruption in commodity markets.