Curmi & Partners

Asset Prices Supported by Dovish Central Banks

by Matthias Busuttil

The strong rebound in equities globally following the slump during the final quarter last year marks the strongest rally seen over the last decade during the same period. All asset classes, from sovereign bonds to emerging market bonds and equities, have contributed to uplift the market value of investors’ portfolios so far this year.

While this development is most certainly welcome, the contemporaneous move in low-risk assets, such as high-quality sovereign bonds, and riskier assets, including credit and equities, reminds us of similar market conditions that prevailed throughout 2016 and 2017. This period was mainly characterised by a low growth and low inflation environment coupled with a strong commitment by central banks to maintain easy financial conditions through low interest rates and monetary injecting programmes.

Similarly, this time round, market indicators suggest that the appreciation in financial assets is less driven by economic improvements but is mainly the result of the renewed commitment by central banks to maintain a dovish stance and hold interest rates steady for the time being.

The chart included below shows the movement in the 10-year benchmark bond yields adjusted for inflation in Europe and in the US (with inverted axes) compared to the forward price-earnings multiples and forward earnings estimates per share of the respective equity markets. Given that expected earnings per share have remained relatively range-bound, it is noted that the expansion in the price-earnings multiple is primarily explained by the drop in real benchmark bond yields – which are a proxy of the discount rate in asset valuations.

The resumption of positive correlation across asset classes, as the economic outlook and inflation outlook remain subdued, shows that the underlying element driving markets is short-term interest rates which are steered by interest rate policy and central bank’s guidance on the future path of policy rates.

Not only does this confirm that central bank involvement remains a major force in the current market environment, but we are also seeing a greater degree of sensitivity by the policy makers to the direct market reactions when asset valuations are not the primary target of their policy.

The risk to the outlook is that buoyant equity markets have been supported by a lot of expectations that yields will remain low. As things stand today, further upside in equity valuations and credit spread compression seems limited. With yields trading back to these low levels, the rally could potentially be sustained by positive surprises in the earning season. Having said that, earnings growth expectations for the rest of the year and next year are unlikely to be revised significantly upwards given the weak business sentiment and the challenging geo-political landscape.

On the other hand, low inflationary pressures may push central banks to consider cutting interest rates once again, but soft data may raise other concerns on the outlook of risky assets.

The balance of risks seems to favour markets in an economic area with relatively stronger fundamentals, such as the US, which may sustain the divergence in financial market performance versus other regions. Secondly, issuer profiles with a focused operational exposure to that economic area are likely to yield superior results compared to issuers with international exposure.

Given where we are in the economic cycle, it is becoming increasingly important for investors to add protection in their risk exposure by adopting a more defensive approach in security selection. While the market rally may extend further, investor should start considering reallocating capital from positions with high return potential in favour of low return alternatives with lower downside risk.


The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.