Exposure rates of the Dorval Asset Management Range – 18th February 2022
The MSCI World has shed 6.9% YTD (in dollars, as at February 17, 2022), which is relatively limited given the sharp surge in risk faced by the financial markets as regards inflation and interest rates, along with geopolitical issues i.e. Ukraine. Corporate earnings momentum can probably explain this relative resilience, with EPS up 2.6% YTD or a 17% jump in annualized terms. The P/E on the MSCI World has therefore slid by close to 10% since the start of January, which is already a significant correction (cf. chart 1).
The swift surge in profits curbs the decline on the equity markets
12-month forward EPS and P/E (source Bloomberg)
Earnings per share / MSCI World / P/E on MSCI World
If we look back to past showings, the recent decrease in P/E completes a trend that had kicked off at the start of last year (cf. chart 2). Overall, the P/E on the MSCI World has plunged 20% since the first quarter of 2021, which is both rational and healthy: investors would have been wrong to extrapolate the very robust rebound in profits under way since the summer of 2020. However, the fact remains that at 15.5x expected earnings, the P/E multiple on the MSCI World equal weighted index – which adjusts for the effects of the priciest stock-market heavyweights, particularly large US stocks – has revisited its historical average.
P/E on equity markets revisit pre-Covid levels
12-month forward P/E, MSCI World (source Bloomberg)
P/E on MSCI World / P/E on MSCI World equal weighted index
This normalization in P/E is not merely reassuring, it is also somewhat surprising as real rates remain extraordinarily low. It is as if investors had already factored in real long-term rates’ return to pre-Covid levels (cf. chart 3). The equity risk premium to bonds therefore looks very lofty, with the MSCI World equal weighted index offering real returns of 6.5% over the long term vs. -0.5% for US 10-year Treasury bonds.
Returns on equities offer comfortable margin vs. bonds
_Real yield on MSCI World equal weighted index (=inverted P/E) / Real rate on US Treasury bonds (TIPS)
Equity risk premium_
This simple calculation suggests that a significant portion of risks faced by the market are already priced in, although this observation offers no guarantees for the short term. Investors will continue to be rattled by the series of events in Ukraine – where the stakes are potentially high – and by the range of inflation indicators that appear on our screens each week. The fact remains that a likely continuation in robust profit growth in 2022 could further drive down equity valuations and end up convincing investors to take risk exposure again.
The timing for this reawakening remains highly uncertain, and so we maintain our moderate allocation in our flexible funds. In our international strategies, the equal weighting for our equity allocation offers a portfolio with a valuation significantly below the MSCI World weighted by market capitalization.