Daniel Morris, Senior Investment Strategist, answers questions on the outlook for asset classes for 2018. This is an extract from an interview published in 'The tide is high', our Investment Outlook for 2018. To obtain a full copy of the outlook, please click here
The performance of equity markets has been excellent in 2017. Is it time to start talking about a return of ‘irrational exuberance’ when looking at the asset classes for 2018?
No, certainly not yet. As high as equity valuations are, in our view, they are not at extreme levels. Former US Federal Reserve Chair Alan Greenspan famously made his comment about irrational exuberance in December 1996, when the forward price-to-earnings (P/E) ratio for the S&P 500 index was at just 15.7 times; the market continued to rise for three more years.
The P/E multiple on the S&P at the time of writing is at just over 18 times earnings, and so well above the level at which Greenspan made his comment over twenty years ago.
But, in relative terms, it is similar. At the time of Greenspan’s observation, the market multiple was 21% above its historical average up to that point. The current S&P 500 P/E ratio is a comparable 24% above its present historical average, nearly one standard deviation above the long-run average.
Although other metrics do show even higher valuations, notably price-to-book, some are more measured. P/E multiples relative to expected growth rates (PEG) are actually at below average for most markets.
It is only modestly above average for the US stock market. This suggests to me that despite the relatively high forward P/Es, analysts expect earnings growth to be strong enough to support them.
Of course, this rosy outlook assumes analyst forecasts are accurate and experience tells us that this is unlikely. However, in a world of accommodative monetary policy and low inflation, equity valuations are perhaps justifiably elevated.
Another argument to support higher-than-average multiples is currently low inflation and the widespread expectation that it will remain so for quite some time yet.
The inflation-adjusted equity earnings yield in the US is currently only 40 basis points (bp) below its long-term average and appears sustainable at these levels. But with the US unemployment rate set to drop possibly to below 4% and little excess capacity in the economy, inflation could yet rise.
This is something markets are certainly not expecting. Were long-term inflation expectations to rise by 25bp (to the level of two years ago), that would imply just a 4% drop in equity prices if the real earnings yield remained constant. So, a modest rise in inflation in the US would not necessarily precipitate a significant re-rating of the equity market.
Asset classes for 2018: developed equity markets
Economic growth is a necessary condition for equity markets to rise, but not a sufficient one and there are two ways in which markets can continue to appreciate in 2018: rising earnings or rising multiples.
The outperformance of US equities versus Europe during most of 2017 was driven by multiples expansion, not by superior earnings growth. In 2018, the challenge for US equities centres on their ability to live up to the already high (forward) multiples and optimistic earnings growth expectations. Analysts currently forecast a gain of almost 12% in US earnings in 2018 compared to just 9% in Europe (see Exhibit 1).
Exhibit 1: Forecast year-on-year earnings growth in 2018 (in %)
Note: Growth in US dollar terms
Source: IBES, BNP Paribas Asset Management, as of 30/10/2017
It is encouraging, however, that expected earnings growth for 2018 is actually below what is forecast for 2017: 10% in 2018 for developed markets versus 12% in 2017, and 12% for emerging markets in 2018 versus 22% in 2017. Even in the case of negative revisions to these estimates, we believe it is reasonable to expect gains in earnings in 2018 and hence market appreciation on constant multiples.
The question then is how sustainable are such multiples when leading central banks are moving, however slowly, to unwind their extraordinarily loose monetary policies. The Fed could raise US interest rates by 75bp-100bp in 2018, and it is likely that the ECB will no longer be buying government or corporate bonds by December 2018.
Asset classes for 2018: bonds
Nonetheless, we do not see rising interest rates as a likely trigger for a bond market sell-off. Rates are already rising in the US because growth is strong, so any negative impact from higher interest costs should be more than offset by the benefits of growth for corporate profits. Thanks to significant amounts of debt refinancing over the last several years, interest costs are generally extremely low for companies, despite higher levels of debt.
Given that the pace of policy adjustment in the eurozone is likely to be slow and that there will still be a meaningful level of reinvestment of maturing bonds by the ECB, we do not expect eurozone yields to rise sharply, either.
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Investment Outlook 2018 - The tide is high