Fixed Income

Over our main 6-12 month investment horizon, valuation has very little ability to predict asset returns. Over longer periods, however, valuation is highly relevant and should be an important part of strategic asset allocation decisions. Our review of the valuation condition of major asset classes suggests that ex-US stocks and ex-US developed market currencies are the primary assets that could reasonably be considered “cheap” today. The value of long-maturity US Treasurys has improved considerably compared with the average of the past decade, when they were significantly overvalued. 10-year US Treasurys are fairly valued today, but not cheap. The US dollar is extremely overvalued to a degree that has only been associated with subsequent structural declines. The yen and European currencies are the most undervalued relative to the dollar, with commodity currencies (outside of NOK) still cheap but less so. We find that no major commodity groups are cheap, although oil is fairly valued. Gold’s overvaluation is extreme. Based on our expectation that the US will enter a recession at some point over the coming year, we are cyclically positioned against the message from our valuation indicators in favoring US versus global ex-US equities, the US dollar, and growth versus value stocks. We are likely to recommend reducing exposure to these assets earlier than would otherwise be the case once recessionary dynamics take hold in financial markets. Chart II-1Valuation Does A Good Job Of Predicting Long-Term Returns August 2023 August 2023 BCA Research’s primary objective is to provide investors with top-down investment strategy recommendations aimed at improving portfolio performance on a 6-12 month time horizon. Over that time horizon, valuation has been shown to have nearly zero ability to predict asset returns. However, ten-year regressions relating current equity valuations to future ten-year compound returns tend to be highly predictive (Chart II-1), even though these relationships tend to be influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Thus, over our primary investment horizon, valuation is not an especially important investment tool. Over a structural time horizon, however, valuation is important, and should strongly inform investors’ strategic asset allocation decisions. In this Special Report, we discuss some simple approaches that we use when valuing the major asset classes that we cover, and provide some conclusions about where investors can find value today in global financial markets. We conclude that global ex-US equities and ex-US developed market currencies are the main assets that can be considered “cheap” today. US stocks are meaningfully overvalued, and this overvaluation goes beyond the region’s heavy overweight toward broadly-defined technology stocks. Some of the US equity premium is warranted due to the US’ large ROE advantage over other countries, but the pricing of US stocks is extreme even after accounting for this effect. Chart II-2Valuation Today Implies Poor Future Returns From US Equities Valuation Today Implies Poor Future Returns From US Equities Valuation Today Implies Poor Future Returns From US Equities If global ex-US outperformance does occur over the coming decade due to equity multiple mean-reversion, it is an open question whether it will occur due to active outperformance of global ex-US stocks or simply due to the stagnation of the US equity market. Chart II-2 highlights that today’s 12-month forward P/E ratio would imply a 10-year future total nominal return from US stocks of just 4.2%. That is roughly in line with the total return of global ex-US stocks over the past five years, and slightly below the average of the past ten years. We previously had more confidence in poor US equity performance due to disappointing earnings growth for broadly-defined technology stocks, but the potential impact of AI models – whether they can be effectively commercialized and whether they can escape regulatory shackles – has significantly raised the uncertainty over this question. In contrast to what has been a long period of overvaluation for US long-maturity government bonds, we find that 10-year Treasurys are fairly valued today (but not cheap). Still, in contrast to expensive global stocks (driven entirely by US overvaluation), investors should clearly be overweight US government bonds. Within the currency and commodity space, we find the US dollar to be extremely overvalued to a degree that has only been associated with subsequent structural declines. The yen and European currencies are the most undervalued relative to the dollar, with commodity currencies (outside of NOK) still cheap but less so. We do not find any commodities to be cheap, although oil is fairly valued. Industrial metals and gold both show up as expensive according to our approach. Gold’s overvaluation is extreme. One wildcard for industrial metals will be the net impact of the interplay between a likely decline in China’s base metals demand, a structural rise in developed market demand due to decarbonization policies, and seemingly tight supply. It is possible that industrial metals are richly priced due to expectations of a price squeeze, making the timing and magnitude of any structural decline in Chinese base metals demand an extremely important factor for investors to monitor. Cyclically, we are positioned consistent with the message from valuation on our global asset allocation recommendation that investors should be underweight stocks, our recommendation that investors should be long fixed-income portfolio duration, and our view that investors should avoid cyclically-sensitive commodity exposure. Based on our expectation that the US will enter a recession at some point over the coming year, we are positioned against the message from our valuation indicators in favoring US versus global ex-US equities, the US dollar, and growth versus value stocks. In each of these cases, we agree that reversion to more favorable valuation is possible or likely following the next US recession, and we are likely to recommend reducing exposure to these positions earlier than would otherwise be the case once recessionary dynamics take hold in financial markets. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Equities One of the first ways that we examine the valuation of global equities is by assessing the valuation of the US equity market. The US market accounts for over 60% of global equity market capitalization, and has been an important driver of the global market over the past decade. We publish our suite of US equity indicators in Chart III-1 of each month’s report, which includes our BCA US Valuation Indicator. There is no single accepted way to value the equity market. The most common measure is the price-earnings ratio (PER), but even that has complications because there are many different definitions of earnings (e.g. reported, operating, trailing, forward, cyclically-adjusted). Meanwhile, the market can also be valued in terms of balance sheet ratios or yields relative to those from competing assets. The BCA approach has been to combine a variety of different valuation measures into one composite index. In building our valuation indicator, we started by sorting valuation measures into three broad groups: those related to earnings (or earnings proxies), balance sheets, and relative yields. Valuation indicators for each of these sub-groups are then combined to produce the overall BCA Valuation Index. The three sub-groups are given equal weight in the overall index, which has been constructed using data back to 1955. Below we list each of the components included in the index and their justification, in order to understand what is driving the message from the index: Chart II-3Earnings-Based Measures Point To US Equities Being Expensive Earnings-Based Measures Point To US Equities Being Expensive Earnings-Based Measures Point To US Equities Being Expensive The Earnings Group There are five components to the earnings group (Chart II-3): The S&P PER based on trailing operating earnings: This is a straightforward calculation of the PER using a four-quarter total of operating earnings as published by Standard & Poor’s. The S&P PER based on a 10-year moving average of trailing reported earnings: The idea here is to use a long-run moving average of earnings in order to smooth out cyclical swings. Moreover, we use reported earnings because persistent write-offs should not be ignored. The S&P 500 Growth PER: Investors are paying for both income (dividends) and growth when they invest in the market. The price paid for income can be estimated by dividing dividends per share by the corporate bond yield. Subtracting this value from the S&P 500 index leaves the price paid for growth. As growth must come from retained earnings, the growth PER is calculated by dividing the imputed price paid for growth by retained earnings. A three-year smoothing of dividends and earnings is used in the calculation of this ratio. The S&P 500 price-to-sales ratio: Measures of the PER can be influenced by temporary shifts in margins. A price-to-sales ratio can thus give a different perspective. Stock market capitalization as a percent of GDP: Unless the corporate sector was taking an ever-rising share of the economy, there is no reason why stock market capitalization should increase its share of the economy over time. Thus, major over (or under) shoots in this ratio can highlight shifts in valuation. The Yield Group There are four components in this group (Chart II-4): The real corporate bond yield minus the S&P earnings yield: the earnings yield is a “real” concept and thus should be compared to a real bond yield. We take the average of the AAA and BAA corporate yield and deflate it with our measure of long run inflation expectations. The earnings yield is simply the inverse of the PER based on trailing operating earnings. The real corporate bond yield minus the smoothed S&P earnings yield: The calculation is the same as described above, except that the earnings yield is based on a 10- year average of reported earnings (i.e., the inverse of the second PER listed above in the Earnings Group). The 10-year Treasury yield minus the S&P earnings yield: This is the so-called “Fed Model” and is the inverse of our equity risk premium (except that bond yields here are measured in nominal terms for simplicity). The 3-month Treasury Bill yield minus the dividend yield: This captures competition that stocks face from cash. The Balance Sheet Group There are two components to this group (Chart II-5): Chart II-4Interest Rate Measures Point To Fairly Valued US Equities August 2023 August 2023 Chart II-5Balance Sheet Measures Point To US Equities Being Expensive Balance Sheet Measures Point To US Equities Being Expensive Balance Sheet Measures Point To US Equities Being Expensive Chart II-6Our Composite Valuation Index Shows US Stocks Are Significantly Overvalued Our Composite Valuation Index Shows US Stocks Are Significantly Overvalued Our Composite Valuation Index Shows US Stocks Are Significantly Overvalued The market value of corporate equities relative to corporate net worth at market value: This data comes from the Financial Accounts of the United States (Table B.103) and relates to the non-financial corporate sector. The market value of corporate equities relative to corporate net worth at historical cost: This measure is the same as above, except that the sector’s tangible assets are valued at book cost as opposed to replacement value. Chart II-6 shows the three groups together with the overall Valuation Indicator. The chart makes it clear that the US equity market is significantly overvalued, just not as extremely overvalued as it was during the late-1990s and during the early phase of the pandemic. While the interest rates group is signaling neutral valuation levels and the balance sheet group appears somewhat distorted by the value of equities relative to net worth at historical cost, the overvaluation of US stocks is clearly reflected in the earnings group. Is the apparent overvaluation of US equities justified by superior fundamentals? Chart II-7 shows that the US does deserve to be priced at a premium relative to global ex-US stocks, given that the return on equity of the US market is almost seven percentage points higher than is the case for global ex-US. However, Chart II-7 suggests that US stocks are seemingly 30% overvalued versus global ex-US stocks even considering the relative ROE advantage. Clearly, a good portion of the US equity market’s overvaluation versus its global peers relates to broadly-defined technology stocks. Chart II-8 highlights that global growth stocks are very expensive compared to value stocks, even after accounting for the premium typically paid for the former. The US market is significantly overweight growth / broadly-defined technology stocks, which accounts for an important part of US / global ex-US valuation discrepancy. Chart II-7Some Premium Is Justified For US Stocks, But Better Fundamentals Do Not Explain US Valuation Levels Some Premium Is Justified For US Stocks, But Better Fundamentals Do Not Explain US Valuation Levels Some Premium Is Justified For US Stocks, But Better Fundamentals Do Not Explain US Valuation Levels Chart II-8The US Is Overweight Growth Stocks, And Growth Stocks Are Especially Expensive The US Is Overweight Growth Stocks, And Growth Stocks Are Especially Expensive The US Is Overweight Growth Stocks, And Growth Stocks Are Especially Expensive Chart II-9Almost Every US Equity Sector Is More Expensive Than Its Global Ex-US Counterpart August 2023 August 2023 But Chart II-9 shows that it is not just broadly-defined technology stocks. The chart shows the current 12-month forward P/E ratio for all GICS level 1 sectors for the US and global ex-US MSCI indexes, as well as the current P/B ratio. Broadly-defined technology encompasses stocks that are included in the consumer discretionary, communication services, and information technology sectors, and the chart shows that US stocks in these sectors are comparatively expensive (in addition to their higher weight in the index). US equity sectors are, however, also comparatively expensive in almost every case on both measures, with the exception of US health care stocks based on the 12-month forward P/E ratio. So it is clear that the US market carries a valuation premium, that is augmented by a heavy index skew toward richly-priced tech stocks. For now, it is not clear whether a catalyst exists to cause global ex-US stocks to outperform US stocks. Cyclically-speaking, we expect US stocks to outperform global ex-US because the US dollar is a reliably countercyclical currency, and because growth/tech stocks should disproportionately benefit from falling interest rates. We would expect a period of active global ex-US outperformance following the next US recession, but whether that is likely to be sustained is an open question. As we concluded in our October 2021 report,1 global ex-US outperformance, or the end of its structural underperformance, may instead occur passively via the end of US outperformance. While this could come in response to a structural decline in the dollar (which is also overvalued, see below), it is more likely that a period of poor US equity performance would only occur in response to a structural slowdown in broadly-defined tech sector earnings. We previously had fairly high confidence that this would occur at some point over the coming few years, although today the structural trend in tech sector earnings is likely very linked to whether AI-related software products can be effectively commercialized and whether they will face significant regulatory headwinds. This remains an open question, and should be revisited after the period of cyclical outperformance that we expect from global ex-US stocks following the next US recession. US Government Bonds While there are a variety of methods that investors can use to value equities, there is considerably more agreement about how to (conceptually) value government bonds (especially US Treasurys). All fixed income investors have a choice when buying US government bonds: they can purchase a 3-month Treasury bill and perpetually roll over the position as it matures, or they can purchase a Treasury bond of a longer maturity. This means that yields on longer maturity Treasury bonds simply reflect investor expectations for the average 3-month T-bill rate over the life of the bond, plus some positive risk premium (the “term premium”) to compensate for the inherent uncertainty of the path and tendency of short-term yields. Thus, government bonds are fairly valued when they reflect the right expectations for future short-term interest rates and when the term premium is reasonable. All major estimates of the term premium treat it as the difference between prevailing 10-year yields and an estimate of the future path of short-term rates. Of course, correctly projecting the future path of short-term interest rates is not an easy task, nor is estimating the term premium. It is for this reason that bonds are often valued empirically, or using an equilibrium framework. Chart II-10 presents one empirical approach: our US 10-Year Bond Valuation index. The index is constructed by regressing the nominal 10-year Treasury yield against an average of real short-term interest rates and inflation, and has done a fairly good job in the past of signaling extreme over/undervaluation. One flaw in the model is that it assumes the recent history of the real fed funds rate is what should be expected under normal conditions, which clearly was not true during the last economic cycle. As such, the model suggested that 10-year Treasurys were fairly valued or cheap from 2013-2018 (we disagree). But abstracting from the global financial crisis and its aftermath, the model has done well. Chart II-11 presents our preferred equilibrium approach. In theory, short-term interest rates should be in line with neutral or equilibrium policy rates over long periods of time. And as we discussed at length in a previous report,2 trend GDP growth is by far the dominant driver of the neutral rate. Faster (slower) growth will incentivize firms to expand (reduce) capacity in anticipation of rising (falling) demand, and faster (slower) growth in aggregate income will raise (lower) the sustainable level of interest on borrowed funds for both investment and consumption. This will elevate (reduce) the neutral rate of interest. Chart II-10US 10-Year Treasurys Are Fairly Valued According To Our Bond Valuation Index US 10-Year Treasurys Are Fairly Valued According To Our Bond Valuation Index US 10-Year Treasurys Are Fairly Valued According To Our Bond Valuation Index Chart II-11An Equilibrium Approach Says US Government Bonds Are Not Cheap, But Are Fairly Valued An Equilibrium Approach Says US Government Bonds Are Not Cheap, But Are Fairly Valued An Equilibrium Approach Says US Government Bonds Are Not Cheap, But Are Fairly Valued As such, our equilibrium approach to US government bond valuation focuses on comparing nominal 10-year yields to available estimates of trend growth. Chart II-11 illustrates this approach, and highlights that while US government bonds have offered better value in the past, they are essentially fairly valued today after a long period of overvaluation. What about the term premium? On this front, the perspective is more complicated. Chart II-12 shows that model-based estimates still point to a low term premium, whereas our best available survey-based estimate is pointing to a significantly higher premium. Our approach has typically been to average these estimates, and based on that the term premium is low but nowhere near as low as it was during the depths of the pandemic. Chart II-13 highlights that changes in the expected average policy rate have been far more responsible for the structural decline in US 10-year Treasury yields than the term premium has over the past fifteen years. As such, despite a low reading on our estimate of the term premium, we are more inclined to focus on the neutral valuation readings from our Bond Valuation index and our preferred equilibrium approach. Thus, US long-maturity government bonds do not offer good value, but they are no longer overvalued like they were for many years and thus offer a good alternative to global equities (especially US stocks). Chart II-12The US 10-Year Term Premium Is Not High, But Not As Low As Before The US 10-Year Term Premium Is Not High, But Not As Low As Before The US 10-Year Term Premium Is Not High, But Not As Low As Before Chart II-13The Expected Future Fed Funds Rate Has Been A More Important Driver Of Yields Than The Term Premium The Expected Future Fed Funds Rate Has Been A More Important Driver Of Yields Than The Term Premium The Expected Future Fed Funds Rate Has Been A More Important Driver Of Yields Than The Term Premium       Currencies Chart II-14The US Dollar Is Extremely Expensive According To Our PPP Models The US Dollar Is Extremely Expensive According To Our PPP Models The US Dollar Is Extremely Expensive According To Our PPP Models When valuing currencies, BCA’s Foreign Exchange Strategy service relies heavily on a PPP valuation approach.3 Chart II-14 presents two separate PPP models for the US dollar: our original PPP model and a new version with refined methodology. Our original PPP models were rooted in comparing national CPI baskets with equal weights assigned to the constituents. First, we divided the national CPI indices into 5 subgroups. These included Group A (food, restaurants, and hotels), Group B (shelter), Group C (apparel, health, culture, and recreation), Group D (energy and transportation) and Group E (household goods). Our new model now includes 10 groups, in order to get closer to an apples-to-apples comparison across countries. Second, we ran two regressions with the exchange rate as the dependent variable. The first regression shown in Chart II-14 used the relative price ratios of each subgroup as independent variables. The second regression took a weighted average of the subgroups to form a single “synthetic price ratio.” The weights were determined as the average of the two countries. So, for example, if housing is 38% of US CPI and 18% of European CPI, the synthetic ratio for EUR/USD will assign a 28% weight to housing. This gives as a more accurate cross-sectional comparison of the two national CPIs. Chart II-15 presents another method of valuing the US dollar, which involves regressing the US real effective exchange rate against relative productivity trends and real bond yield differentials. The core point of Charts II-14 and II-15 is that the US dollar is extremely expensive based on either of these approaches, and that similar periods of overvaluation in history have been associated with subsequent structural downtrends in the currency. Chart II-16 presents over/undervaluation estimates for major developed market currencies based on the PPP approach noted above. The chart highlights that US dollar overvaluation is primarily mirrored by undervaluation in the yen and European currencies excluding Sterling. Commodity currencies such as the CAD, AUD, and NZD are the least undervalued against the dollar, although NOK trades at close to a 20% discount to fair value according to our models. Chart II-15The Dollar Is Also Expensive Based On Relative Productivity And Real Yields The Dollar Is Also Expensive Based On Relative Productivity And Real Yields The Dollar Is Also Expensive Based On Relative Productivity And Real Yields Chart II-16The Yen And European Currencies Are Very Cheap According To Our PPP Models August 2023 August 2023 The bottom line for investors is that the US dollar is extremely overvalued and thus vulnerable to a structural decline. We currently recommend that investors position favorably toward USD, but for cyclical reasons that are strongly linked to our expectation of a US recession emerging over the coming 6-12 months. Given how richly priced the dollar is relative to other major currencies, we are highly likely to recommend reducing USD exposure before the end of the next US recession. Commodities It is very difficult for investors to value commodities using traditional approaches because direct commodity holdings provide no cash flow for investors to discount. Many of the commodity “valuation” models offered up to investors actually track deviations in prices from cyclical drivers, which is not truly what investors want to know when they ask whether an asset is fairly priced. For industrial/cyclically-sensitive commodities, one method of measuring fair value is to gauge whether the cost of consuming the commodity is elevated relative to economic activity. For oil, Chart II-17 illustrates our calculation of the “global oil bill”, i.e., global expenditure on oil as a percent of global GDP. Based on this measure, the chart shows that oil is fairly valued. Chart II-18 presents a similar approach for global copper consumption, albeit over a shorter time horizon. Chart II-18 suggests that copper prices are likely overvalued, in the sense that the “global copper bill” is much closer to its 2005-2015 average than is the case for oil. Chart II-17Oil Is Fairly Valued Oil Is Fairly Valued Oil Is Fairly Valued Chart II-18Copper Seems Overvalued Copper Seems Overvalued Copper Seems Overvalued Chart II-19Real Raw Industrial Prices Are Too High Real Raw Industrial Prices Are Too High Real Raw Industrial Prices Are Too High Another potential method for valuing commodity prices is to examine the long-term trend in real commodity prices and whether current real prices are elevated or depressed relative to that trend. In the case of industrial commodities, we would expect that the trend in real prices is either flat or down over time due to technological improvements in commodity extraction and the relative abundance of most industrial metals in the earth’s crust. Chart II-19 highlights that the very long-term trend in real raw industrials prices is indeed down, and that prices today are overvalued in a way that is consistent with Chart II-18. Under normal circumstances, the combination of seemingly overvalued industrial metals prices and a clear shift in China’s attitude toward its metals-intensive property sector would lead to a very negative structural outlook for base metals prices. However, one complication is that decarbonization efforts globally will clearly require a significant increase in industrial metals consumption from developed economies, and there have been several warnings from major industry players that key metals supply is tight and could threaten the transition to green energy. Thus, it is possible that elevated real industrial metals prices today reflect expected future demand / scarcity from the coming shift away from fossil fuels. Finally, turning to gold, a similar analysis of the long-term trend in the real price of gold is the only reasonable valuation method that we feel comfortable using given that gold provides no cash flow and has very little industrial demand as a share of total demand. Unlike real industrial metals, we agree that gold should act as a hedge against inflation over the long term, so we would expect the real price of gold to at least trend sideways over time. Chart II-20Gold Is Extremely Overvalued Gold Is Extremely Overvalued Gold Is Extremely Overvalued Chart II-20 highlights that this has indeed been the case since the 1970s, and that gold is extremely expensive based on this valuation approach. Somewhat similar to the case of industrial metals, one could potentially point to future sources of demand for gold as a basis for currently expensive gold prices. First, while widespread concern about the US fiscal position has existed for many years, it is possible that the US government’s interest burden will break above its early-1990s levels before the end of this decade. Given that a fiscal crisis in the US would very likely be dollar-negative, this could potentially justify elevated gold prices today. Second, following Russia’s invasion of Ukraine and the sanctions levied in response, China has significantly increased its gold holdings in an attempt to “de-dollarize”. We are skeptical that China can continue to do this over the longer term, but it is a possibility – especially considering China’s ambitions toward Taiwan. The bottom line for investors is that none of the major commodities classes are cheap in absolute terms, but our valuation indicators point to the order of least expensive to most expensive being: oil, then industrial metals, and then precious metals. Footnotes 1 Please see The Bank Credit Analyst "The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms," dated September 30, 2021, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst "The Fed’s Low Neutral Rate View: Fact Or Folly?" dated February 23, 2023, available at bca.bcaresearch.com 3    Please see Foreign Exchange Strategy "Currency Valuation And Long-Term Returns: Part I," dated January 20, 2023, available at fes.bcaresearch.com

In Section I, we audit the market’s “soft landing” narrative in response to a meaningful challenge to our cautious stance from recent financial market developments. We acknowledge that US economic growth was stronger in the first half of the year than many investors expected, but we are unmoved by the recent uptick in “soft landing” hopes. A “soft landing” outcome very likely necessitates interest rate cuts before recessionary dynamics emerge, and it is far from clear that rate cuts or (especially) an easy monetary policy stance are likely to materialize over the coming year. As such, we continue to believe that conservative portfolio positioning is appropriate. In Section II, we discuss some simple approaches that we use when valuing the major asset classes that we cover. We conclude that global ex-US equities and ex-US developed market currencies are the main assets that can be considered “cheap” today.

A brief recap of the July FOMC meeting and its investment implications.

Stay cautious on Chinese stocks. Equity investors should use any rebound in onshore stock prices to downgrade A-shares from overweight to neutral within global and EM equity portfolios. Remain underweight Chinese investable/offshore stocks. Onshore bond yields will drop to all-time lows. Continue receiving 10-year swap rates. The currency will continue depreciating versus the US dollar in the coming months.

This week we preview the July FOMC meeting, provide an update on the Fed’s balance sheet and recommend a new TIPS trade.

China’s economy is cruising at a very low altitude where gravity forces are intense. Downbeat consumer and business sentiment will reduce the effectiveness of stimulus. Anything short of “irrigation-style” stimulus will be insufficient to boost growth. We remain cautious on Chinese stocks. Onshore bond yields will drop to an all-time low. The RMB is still vulnerable against the USD in the next few months.

In this report, we present our performance review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the Q2/2023, and the outlook and scenario analysis for the next six months. The portfolio return exactly matched that of the benchmark index during the quarter, as modest gains on government bond allocations in the US, UK and core Europe completely offset losses on spread product underweights. Looking ahead, the portfolio is positioned to capitalize on an expected slowing of global growth over the rest of the year through an overweight stance on government bonds versus spread product and above-benchmark duration tilts in the US and core Europe.