By Joseph Little
Many investment strategists compare valuations to historic averages and conclude that equity markets are very overvalued today. We disagree. We argue that valuation analysis needs to be conducted in the context of the likely future macro-economic and interest rate environment.
A popular concern among investment strategists today is that classical valuation metrics look high relative to historic norms. This leads them to the conclusion that equities are overvalued and future returns are likely to be weak. The so-called Shiller PE, a popular price-earnings multiple which compares smoothed earnings to the current price, is currently at 28x relative to an average of 18x since 1881.
Other price-based valuation metrics imply the same conclusion. This is important for investors since even if the current rating mean reverts only slowly, future returns will be hampered. If mean-reversion were to occur more quickly, future returns could be very negative.
We disagree with this view.
First, as asset allocators, we need to think about the attractiveness of different asset classes relative to the competing opportunities of today. The fact that equity markets might appear expensive relative to their own history is interesting, but is irrelevant for investors making decisions today. Much more important, we believe, is the relativity of value and its safety.
Second, we believe the popular view from above is a logical fallacy. Valuation analysis needs to be done in the context of the evolving macro-economic and interest rate environment. The “normal” rating of the equity market is not a fixed and static concept, but it is contingent on today’s fundamentals. This means that comparing simple equity price multiples relative to their historic norms embeds a strong assumption. Namely, that interest rates will also mean-revert back to its historic levels.
Since the 1980s, bond yields have compressed structurally from 15% to below 2%. This has profound implications for how risk assets should price themselves. According to finance theory, equity pricing reflects a risk free rate and a “risk premium” (additional reward) for bearing cash-flow risk. In other words, if the interest rate environment shifts, our return expectation for equities also changes.
So, how should we approach asset valuation? We need to address this in a consistent way over time and across different asset classes. Instead of using classic equity price metrics, we build an economic scenario for interest rates and future cash-flows (dividends) for each market. Using current prices, we imply the premium that the market is offering us today. As market pricing shifts, so does our measure of the reward for holding equity risk.
Today, we believe that we are in a “lower for ever – until further notice” interest rate environment. Cyclically, growth remains lacklustre and inflation subdued. On a multi-year outlook, demographics, debt and income inequality mean that the likely path for equities will be much shallower than we have gotten used to in the past. There is a “policy divergence” between major central banks.
In the US, the recovery is much more advanced, yet the Fed is still likely to pursue an “uber-gradual” rate tightening strategy. Meanwhile, in Europe, Japan and the UK, monetary policy is likely to remain very accommodative for the foreseeable future given the additional growth headwinds.
What does this mean for future equity returns? Today’s market pricing implies that we are in a low return world. There is no escaping this reality. But equity returns in the region of 5% for the major developed markets still look reasonable in the context of ultra-low interest rates and negative yielding bonds.
Currently, we estimate an equity premium over cash of 3.1% for the US and 4.0% for Europe. Relative to government bonds, the premium on US equities is 4.6%. Moreover, we make conservative assumptions for dividend growth, which implies that there could be some upside to this estimate.
Against this economic environment, the profits outlook appears okay. But it is a fragile equilibrium. Growth is likely to remain lacklustre, but we don’t anticipate a recession and we believe that policy makers can continue to provide a cushion should the economic news flow deteriorate. On the upside, growth is not yet too hot to worry about a more aggressive rate tightening cycle from the Fed.
Nonetheless, there a number of uncertainties given the unusual economic environment that we find ourselves in. This means that there will be “noise” in markets. We should expect “episodic volatility” as market participants digest new information. This creates some challenges for investors – a backdrop of low sustainable returns and heightened volatility is uncomfortable. But we believe that it will also create opportunities for nimble investors who are willing to be contrarian.
Joseph Little is chief global strategist at HSBC Global Asset Management
