High equity valuations face macro headwinds

We have had a cautious view on global equities for longer than has been comfortable. In truth, over the last 12 months this view has been 50% right at best. European markets, including the UK, have delivered relatively little capital growth. However the US and emerging markets have moved significantly higher. When the headlines are focussed on geopolitical events, it is also easy to lose sight of the anchor of equity valuations. We have updated our equity valuation measures and find that the US market in particular remains notably expensive while European markets still appear overvalued. We recognise that this has in part been justified by the record run of corporate profitability but the factors driving this phenomenon may now be going into reverse.

Exhibit 1: 12m equity market performance in USD

Our cautious view on global equity markets was possibly stymied by the agreement on US tax reform and the surprising weakness of the US dollar combined with persistent commodity strength, even as the Federal Reserve consistently guides towards higher US interest rates. To recap, the components of the original reason for caution were the relatively high level of equity valuations, the likelihood of mean-reversion in terms of corporate profitability and rising global interest rates.

Exhibit 2: Equity valuations remain above average and notably so in US

For equity valuations, we have refreshed the data. Exhibit 2 shows the current market valuation premium versus the 25-year average on a number of measures, with a composite measure in the final column. Unsurprisingly perhaps, following the strong performance and continued run of record-breaking profitability, US equities continue to be highly valued on this composite basis. European and UK equities also remain overvalued but the valuation premium has been shrinking as corporate profits and book values have grown over the past year, with only limited market performance.

It is course also true that high valuations have not been an impediment to progress in global equities in recent years. Furthermore, the fears of a decline in profitability through mean reversion have consistently proved wide of the mark in this cycle to date. EBITDA margins have remained extraordinarily high across listed equities globally. In some respects this is in the US and Europe a continuation of a trend of ever increasing EBITDA margins, which may have started as early as the mid-1990s, Exhibit 3. As a result, price/sales multiples are very elevated but in part due to each dollar of sales producing significantly more EBITDA than in the previous cycle.

Exhibit 3: EBITDA margins have been trending higher in developed markets

While it is not easy to quantify impact of each of the factors behind this long-term rise in corporate margins, the factors themselves are easier to identify. For example, trade liberalisation and consequent globalisation has enabled supply chains to shift to lower-cost countries. This has the combined benefit of shifting production to lower-cost workers and also to regions where there is greater appetite for capital investment. Such a shift qualitatively improves EBITDA margins and may also be responsible for a part of the observed weakness in capital investment for companies listed on developed market exchanges. The fixed asset investments made in emerging markets which support this globalised supply chain model are clearly considerable – and are in our view key to the concerns over a trade war, as expressed by international organisations such as the IMF.

Despite these risks and following a long period of increasing globalisation, the US administration has now opened a formal process providing for increased tariffs on international trade with China. As with Brexit, the key risk in the short-term is investment spend, as it is a significant contributor to the cyclical direction of the global economy. While uncertainty with respect to any ultimate resolution to the trade dispute between the US and China remains elevated, corporate investment plans are at risk of being deferred if not cancelled.

We note that similar fears have arisen during the UK’s negotiations to exit the EU. The Bank of England has estimated that UK business investment is 3-4% weaker than it might have been, due to the uncertainty over Brexit. For equity market prices, investors need nothing more than an expectation of a period of uncertainty to add a risk premium to their outlook for the global economy. Any meaningful reversal of globalisation would also place corporate margins at risk, even if this remains a tail risk at present.

It is still too early to tell how the US administration will ultimately proceed with trade negotiations. The precedent of North Korea shows that the mood within the White House can shift very quickly even if, on the face of it, once opened trade disputes are difficult to resolve quickly. Given the policy volatility exhibited by the current US administration, most recently by raising and dashing days later the prospect of a US return to TPP, we also believe there is little value in tilting a portfolio to favour a specific outcome on US/China trade. Instead, we expect investors to seek a more cautious portfolio positioning.

The second factor operating in favour of cyclically high corporate margins has been the long period of very high unemployment in developed markets following the financial crisis. Indeed, the lack of pricing power of labour and increased share of corporate profits in GDP had become something of a political phenomenon contributing to the surge in populism on both sides of the Atlantic.

However, this weakness in wage growth may already be old news. Labour markets have tightened appreciably over the last 18 months and unemployment in many of the world’s developed markets is now pushing towards cyclical lows with wage growth moving higher.

The final factor is that ultra-loose monetary policy has supported final demand during a period when the pricing power of labour was very weak, maintaining growth in corporates’ top-lines. This has also in our view been a helpful contributor to the exceptional corporate performance during this cycle. It is however clear that this ultra-loose monetary policy is being gradually withdrawn worldwide, led by the US Federal Reserve.

Despite early signs of a slowing of the global economy in both Europe and emerging markets, US policymakers have not backed away from guidance of 3-4 interest rate increases this year, which has finally been embedded in market expectations. We note the New York Fed President Dudley expects US interest rates to become slightly restrictive at as high as 3.4% over the next two years, which in the event would provide significant competition for investors’ dollars away from equities.
Furthermore, the 2-year interest rate differential between the US and eurozone is already at 300bps, a record level which we expect to place upward pressure on the dollar, propagating tighter financial conditions overseas, and notably in emerging markets.

The lags involved may be difficult to estimate with precision but with output gaps closed we believe future monetary and wage growth developments offer only headwinds for markets and levels of corporate profitability over coming quarters. This remains a top-of-cycle environment in our view. After the modest falls from the market highs recorded in January global equities remain expensive compared to historical valuation levels. Record current and forecast profit margins face risks from developments in trade policy and tightening labour markets. With Fed policy clearly remaining on a tightening track, we stick with our cautious view on global equity markets.