US equity valuations look worryingly high but global growth trends are encouraging
Standard Life Aberdeen co-chief executive Martin Gilbert recently argued February’s sell-off was a “welcome and overdue” correction after the record-breaking rally that ushered in the new year. However, Morgan Stanley’s models suggest the equity market could struggle after the first quarter.
Should investors expect more corrections this year? Or perhaps even an end to the nine-year bull run?
Reasons to be cheerful
One significant reason to be optimistic is that signs suggest the global backdrop will remain generally favourable. The global economy grew by 3.35 per cent in 2017 and the International Monetary Fund expects this to rise to 3.9 per cent in 2018 and 2019.
The Chinese economy has been growing at the same rate for the past two years but the eurozone, the country’s largest trading partner by total trade, has been accelerating recently. It grew 2.7 per cent in 2017, close to levels last seen before the financial crisis.
Meanwhile, the Canadian economy grew by 3.3 per cent. Robust global growth should continue to support demand for exports, which – along with the recent fiscal stimulus – will help sustain strong earnings growth.
Donald Trump’s tax cuts and the $300bn of additional federal spending will continue to be a boon to US companies. As figure one (below) illustrates, earnings per share for the S&P 500 are forecast to continue accelerating in the coming months on the back of the fiscal reforms.
If these projections materialise, this should support a rotation out of international equities and into US equities, but given the S&P 500 is a tech-heavy large-cap index, these projections tell us little about the impact on smaller companies. As it turns out, smaller caps are set to be the main beneficiaries.
The corporate tax cut will benefit companies with greater domestic exposure, as the lower rate will apply to a greater proportion of their net profits compared with larger multinationals. This includes smaller companies, which derive a greater proportion of their revenue at home.
The reforms are also expected to support the rotation out of growth and into value, as these stocks also have greater domestic exposure.
This is an important reason for value managers to remain optimistic about the asset class, at least over the coming months.
That said, current valuations seem so stretched that it might be very difficult for these managers to find any value at all.
Indeed, despite the sell-off and the long-awaited return of volatility early last month, US equities remain significantly more expensive than their UK, European and Japanese counterparts.
As figure two shows, price-to-earnings ratios for the S&P 500 relative to the FTSE 100 and STOXX Europe 600 are at their highest levels since the financial crisis. The S&P 500 premium over the TOPIX, on the other hand, is at its highest level since 1993.
Many see high and rising stock valuations as a signal of an impending correction. However, this is ignoring the strong fundamentals which have boosted earnings as well as valuations, and the fact that US companies still lead the world in terms of innovation and efficiency.
That is not to say risks do not remain. One of the most significant sources of risk in the coming months will be the pace of monetary policy tightening by the Federal Reserve.
Interest rates were raised three times in 2017 and for much of the year these were expected to be replicated in 2018.
However, towards the end of the year, the Fed began signalling that an additional hike would come this year. As a result, the market-based probability of four rate rises has risen to around 25 per cent.
The faster rate of monetary tightening will likely slow gains from the tax reforms and strong global demand, especially if it helps the dollar recover more of last year’s losses, but overall there is no reason to be pessimistic about US equities.
Global growth is robust for now and the tax reforms are likely to remain supportive for some time. Although much has been written about the implications of high valuations, there is evidence that they are warranted by the fundamentals in this case.
Jake Hitch is research assistant at FE