JAMIE MCGEEVER: Markets are wary of overstretch as much as overshoot

While investors obsess with “fair value”, markets rarely find it, never mind settle there.

Markets have had good reason for dramatic and sometimes violent repricing due to serial economic shocks over the past two years. But there’s a gnawing sense of overstretch in many areas and a feeling that a lot of upheaval is already priced.

It’s always risky calling turns that never materialise, and markets routinely overshoot — or undershoot — fair values for long periods. Foreign-exchange markets are a great case in point — they often reflect temporary divergences between otherwise highly integrated economies and are a magnet for huge speculative capital flows.

Look at the dollar’s parabolic rally against the yen.

The dollar has soared to a 24-year high above ¥144. It has strengthened more than 25% in 2022, on course for its biggest annual rise as US-Japanese yield spreads have blown out to their widest in favour of the greenback since 2007.

Zoom out a little and the move is even more astonishing. The dollar has strengthened more than 40% since the start of 2021. Dollar/yen is a G3 currency pair, not an illiquid emerging market prone to wild and unpredictable price swings.

A reversal must surely be imminent, right? Yes, say JPMorgan analysts, but not before new highs are reached.

“If policy/rhetoric around the [Japanese] currency remains unchanged, a move toward ¥150 does not look impossible,” they wrote on Monday.

Widening gap

There have been notable moves and wide regional differences in other markets recently.

The Bloomberg global aggregate bond index has slumped as much as 24% from its peak, a record fall. The ICE BoFA US treasury index, meanwhile, is on track for its worst annual performance on record, but is down “only” 11% this year.

The plunge in non-US bonds is reflected in the spread of two-year US yields over euro and UK yields. This widening gap had helped propel the dollar to a 20-year high, but it is now shrinking as European Central Bank and Bank of England rate expectations shift.

The two-year US-eurozone spread has narrowed 40 basis points (bps) in the past month, and the comparable US-UK spread has tightened 100 bps. If the euro and sterling do fall further against the dollar from here, it may not be by much.

“Our baseline assumption is ... that the most rapid phase of sterling underperformance is now behind us,” Goldman Sachs’s currency strategy team reckons, adding: “We see few barriers to dollar/yen continuing to press higher.”

Societe Generale’s Kit Juckes believes the euro, back below dollar parity, will remain anchored at “very low levels” for the rest of 2022. “But we are not sure that we will see much lower levels.”

Bearish

Europe is at the heart of many of these extreme pricing and flow divergences. Take equities.

According to Bank of America, a net 34% of fund managers were underweight eurozone equities in August. That is 2.0 standard deviations below the long-term average, and similar to July’s net 35% underweight, the most bearish position in a decade.

Investors are gloomier on eurozone equities than any other region, sector or asset class. The only region on the global equities map where investors are bullish is the US, with a net 10% overweight position.

Fund flows reflect the divergence. Goldman Sachs’ equity strategists note that investors have pulled money out of West European funds for 29 straight weeks, with total redemptions of $90bn. US equity inflows in the same period are at about $100bn, and about $300bn since July 2021.

The dim view investors have on European stocks has made them significantly cheaper. European equities’ 12-month forward price-earnings (PE) ratio is just above 11.5, according to Morgan Stanley, indicating that they are the cheapest since 2014.

Perhaps they may need to cheapen more before investors buy them again. Morgan Stanley sees a “plausible” risk that the PE ratio will fall to 10, significantly lower than the S&P 500 PE. Iit is currently 16.5, and Morgan Stanley reckons it will stay above 16 for the next 12 months.

“While sentiment and positioning can prompt short-term tactical bounces from time to time, the negative fundamental backdrop [in Europe] suggests that these should be viewed in the context of selling the rally” in contrast to buying the dip Morgan Stanley analysts wrote on Sunday.

Morgan Stanley and Goldman see European stocks significantly underperforming Wall Street over the next six months before realigning next year.

Reuters