Market update and outlook: both surprising and expected
2023 so far: inflation, interest rates, stocks, bonds, gold and more
In this update:
Inflation trends, interest rates and the economy
Stocks: a surprising year so far, and my morally dubious prediction about AI and the "Metaverse"
Bonds: continued weakness year-to-date, but is the worst over?
Gold: treading water, but reasons to hold
We're nearing the half-way point for 2023, so it seems timely to do a market update of how markets are progressing so far. I'll also cover how I'm feeling about prospects for the rest of the year and beyond.
In some respects, it's been a strange first half. Towards the end of last year and early this year, it seemed that most market analysts were recommending taking shelter in deep value stocks. In the event, it's been US growth stocks, especially the mega caps, that have surged this year. But can that last? I'll get back to that.
Over the last 15 to 18 months, the world's main economies went through a major monetary regime change, from ultra-low interest rates to more normal ones.
Central bank policy rates are now, finally, back at comparable levels to those last seen in late 2007 or early 2008. In between, there were around 15 years of severely abnormal rates, by any historical or theoretical yardstick.
During that absurd and prolonged period, it's no surprise that we saw the formation of multiple asset bubbles. Here are a few examples:
In the US stock market, the Cyclically-Adjusted P/E ratio (CAPE*) rocketed to 38.6 by November 2021. That compares with its median (mid-point) since 1872 of 15.9, its pre-Global Financial Crisis (GFC) / pre-crash level of around 27 in 2007, and the all-time tech bubble / pre-crash high of 44.2 in December 2000. (See here for a long-term chart of the US market CAPE.) Having dipped back to a still-high 27.1 by October last year, it has now risen again to 30.5.
The benchmark yield on 10-year US treasury bonds bottomed out at a record low of 0.55% in July 2020 (see here for a yield chart going back to 1962). Given that the prices of already-issued fixed-coupon bonds rise as yields fall, this was a bubble valuation. Even worse, in Japan and parts of Europe, trillions of dollars of bonds reached negative nominal yields in recent years. That meant lenders (bond holders) were effectively paying to lend, which was clearly absurd. Bond prices have crashed since the end of 2021, as yields have returned to more normal levels. That said, short-dated yields are still well below inflation in most developed countries, meaning investors in such bonds are still losing money in real terms.
In the UK, between the late 1960s and year 2000, the ratio of average house prices to average household incomes ranged between 3 and 5 times. At the peak of the pre-GFC housing bubble it got close to 8, before dropping below 7 for a few years. These days, the ratio is well above 9, which is a new record. Because people borrowed huge amounts when rates were ultra-low, and now that mortgage rates have gone up sharply, mortgage costs as a percentage of household incomes are now back above 50%. That level was last seen in the late 1980s / early 1990s (when interest rates were much higher, but debts were much lower relative to incomes). A multi-year house price crash seems highly likely, as borrowers and lenders adjust to the new reality. (Something similar is likely in many European countries, especially where few mortgage borrowers have long-term fixed-rate loans.)
(* The CAPE ratio attempts to smooth out short-term swings in corporate earnings - the "E" in P/E - that are caused by economic cycles. The idea is to give a benchmark for market prices relative to "average" earnings power. It does this by taking earnings-per-share, or EPS, for each of the past 10 years, adjusting the figures for accumulated inflation since, and taking an average. As such, it's a useful benchmark for assessing whether the stock market is trading richly or cheaply.)
That's the general backdrop. Now let's turn to the more recent specifics (for paid subscribers only).