Low volatility, high valuations

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Volatility of US equities is at historic lows

The one thing we can say with certainty is that whenever the VIX volatility index falls below 10 it will subsequently rise above it.

Exhibit 1: Equity volatility (weekly data as of 30/06/2017)

Source: Thomson Reuters, BNP Paribas Asset Management, as of 06/07/2017

Since 1990, the VIX has only dipped below 10 fifteen times, but six of those times have occurred in 2017, so it has been a year of unusually low volatility. Does that mean equity markets are due for a correction? Not necessarily. The correlation between the level of the VIX and the subsequent one-month, three-month, or one-year return in the S&P 500 is near zero. Of all the times the VIX has fallen below the lowest decile (12.1), subsequent one-month returns have in fact been positive nearly two-thirds of the time.

We believe the current drivers of low volatility in equity markets will persist, from supportive central banks to steady earnings growth. There are reasons to be concerned when so many markets are so calm, because any upset could have an exaggerated impact. But as most drivers of low volatility are fundamentally positive, a low VIX is not by itself a reason to expect poor future equity returns.

Valuations of US equities are a concern

Given that we are at a relatively late stage of the US economic cycle and hard economic data suggests that US growth remains subpar, valuations of US equities are clearly a concern. The price-earnings ratio based on expected earnings is around 28% above its long-run average and 39% above average based on price-to-book ratios.

Exhibit 2: Price earning ratio for MSCI World Index and MSCI USA index

Source: Datastream, BNP Paribas Asset Management, as of 06/07/2017

Margins are high, which means it will be challenging for US corporations to generate earnings growth high enough to support such lofty multiples. The question for investors is what will be the catalyst for multiples to revert to the mean. The most likely one is a US recession. The likelihood of one over the next five years is, in our view, around 50%, although we know economists have a rather poor track record of predicting the business cycle. Until the US begins moving towards a recession, we anticipate equity markets will be reasonably stable, though significant appreciation from here is doubtful.

If corporate earnings growth is able to continue, however, some of the valuation problems will resolve themselves. For example, if earnings grow by 10% over the next year, the multiple on the S&P 500 would drop to 16.2x. While this is still high, it seems less worrisome in an environment of steady GDP growth and low inflation. This scenario presupposes, however, that the market does not appreciate. So current US P/E ratios suggest that the best-case scenario over the medium term is flat markets.

Written on 06/07/2017

Daniel Morris

Senior investment strategist, CFA charterholder

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