All financial asset prices have suffered this year, rattled by the highest inflation and the sharpest increase in interest rates in over 40 years, strict Covid restrictions in the world’s second largest economy, the biggest war in Europe since WW2 and an energy supply shock that rivals 1973. Bond yields and the US dollar have surged, and equity prices have plummeted. Further volatility and downside risk probably lies ahead, but valuations are once again looking attractive. Bond yields, the dollar and equity valuations are over 2 standard deviations from their long-term means, which suggests good trading levels for long-term investors. The combination of falling share prices at the same time as continued solid earnings growth has resulted in a sharp derating in global equity valuations. The trailing price-earnings multiple of global equities now lies at 15.2x comfortably below its long-term average of 19.1x.

The bears are waiting for the traditional market capitulation marked by a sharp rise in the VIX volatility index. Equity market volatility has been noticeably absent in this bear market, perhaps because there has been such a strong consensus among investment institutions that markets would drop from mid-2021 onwards. The inflation shock was bound to result in a dramatic tightening in monetary policy. The consensus means very few market participants have been caught unawares and on the wrong side of the market decline. A “blood on the streets” moment might therefore not occur.

Failing to reallocate cash raised over the past 15 months runs the risk of missing out on the best profit-making opportunities. Markets always run hardest at cycle turning points. Current valuations and early signals that the market may be turning offer the opportunity to buy shares that have long been on the radar but were always too expensive. There are several signals that equity markets are getting close to the bottom. It is unclear how quickly inflation will return to target levels but there is growing evidence that inflation is at least turning lower. Gas prices have dropped around 70% from their highs reached in August, due to mild weather and plentiful inventories. Inventories stand at 93% of capacity in Europe. Monetary policy appears to be at peak hawkishness. The Bank of Canada and Reserve Bank of Australia both delivered smaller than expected interest rate hikes in their October policy meetings. The ECB stuck to its 75 basis-point rate hike but adopted a dovish tone in its policy statement. The Federal Reserve is due to follow through with a 75 basis-point increase on 2nd November, but this will likely mark the last of its jumbo rate hikes, to be followed by a 50 basis-point hike in December. By then the fed funds rate will be 4.5%, close to the neutral level and the rate discounted by fed funds futures.

The last rate hikes are always the most painful. There is a growing chorus from economists and even members of the Fed that monetary policy is in danger of over-tightening and creating a financial accident. The riot in the UK gilt market in October, when the 10-year gilt yield gained by 150 basis points in a matter of days, was an early warning signal. According to Macro Strategy Partnership, the US real interest rate is at its highest point since the early 1980s. The research company calculates it by subtracting the 3-month annualised rate of monetary growth from the fed funds rate (currently 3.25%). US monetary supply fell at an annualised rate of 5.02% over the last 3 months. Hence the real US interest rate is 3.25 less minus 5.02 which equals 8.27%. In the context of such rapidly shrinking liquidity and fractures starting to appear in bond markets, it is only a matter of time before the Fed pivots towards a more cautious “wait and see” approach. Quantitative tightening will likely make way for yield curve control, whereby the Fed targets yield levels at the long end of the bond market. This way, the 10-year Treasury yield can be brought lower through intent without necessarily having to commit to actual asset purchases. The result is less inflationary as yields can be brought lower without increasing money supply but at the same time brings borrowing costs lower.

The 10-year Treasury bond yield has jumped from 1.5% to 4.0% since the start of the year. This follows a jump from 0.90% to 1.5% in 2021. As bond yields rise prices fall. According to Bank of America strategist Michael Hartnett, the last time that the Treasury bond fared so badly was in 1788. The last time bond prices dropped two years in a row was in 1959. Apparently three years in a row has never happened, which suggests bond yields are highly likely to come down in 2023, benefitting all financial asset classes, including equities.

OAM has been raising cash in our client portfolios over the past 15 months by selling the weaker share holdings. We have started gradually putting the cash back to work with the initial purchase of JPMorgan American Investment Trust Plc. The share has long been on the radar and now provides an opportune entry level. The US economy has retraced from its excessive valuations earlier this year and once again trades in line with its long-term average price-earnings multiple. The US market is admittedly expensive versus other world markets, but this is largely explained by the heavy weighting of technology and healthcare stocks, which tend to trade at higher multiples. The US private sector, after the decade of deleveraging that followed the Global Financial Crisis, is in rude health. Balance sheets are solid, banks are well capitalised, there are no structural imbalances in the economy. The US is energy self-sufficient and is far removed from the Ukraine war. Third quarter company earnings were stronger than expected. The delayed impact of monetary and fiscal tightening will cause an economic slowdown in 2023 but the expected recession is likely to be shallow and short-lived.

The managers of JPMorgan American say that the market pullback has created opportunities to acquire attractive, high growth companies at more reasonable prices. Managers split their allocation to large-cap stocks equally between growth and value shares so that the balance does not deviate more than 60:40 in either direction. Performance has been boosted over the past year with exposure to material and energy stocks, which still comprise 10% of the portfolio despite some profit taking. Its largest exposure is to information technology at 23% although this is underweight compared with its benchmark, the S&P 500 index. The share has an excellent track record versus its benchmark and its investment company peers. The share is very liquid with a market capitalisation of close to £1.5 billion.