Macro Monthly What about valuations?

The most common pushback we hear to our optimistic view on global equities is: what about valuations? Don’t high forward price-to-earnings ratios mean that all the good news is already priced in, and stocks will be hard-pressed to make further gains?

We believe high multiples are the latest brick in the wall of worry that global equities will climb on their way to fresh all-time highs. Valuation is a key pillar in our investment approach, but it is not the only consideration. The macro backdrop suggests that earnings expectations, the most important determinant of returns over the tactical investment horizon, will continue to rise. And risk appetite, while improved, has not risen to extreme levels. We acknowledge, of course, that elevated multiples on global equities may limit the speed or magnitude of any future rally and make stocks more susceptible to unforeseen shocks.

Macroeconomic conditions in the US, the largest component of global equities, have improved meaningfully in recent quarters. Real growth has accelerated. Inflation has decelerated substantially, with core PCE running just below 2% on a-six month annualized basis. This backdrop has allowed central banks to pivot away from tightening towards easing, and for financial conditions to become more supportive of future economic growth. Consumer and business sentiment is also rising, catching up to other measures of economic activity. Consumers have positive real income growth that enables higher real spending, and businesses should be able to maintain or grow profit margins as they take advantage of increases in volume.

Risk appetite and valuations rise when an improving, solid economic outlook enhances investors’ confidence that corporations will be able to deliver consistent profit growth. And stocks tend to move higher as long as earnings expectations also rise, even if forward price-to-earnings ratios are elevated. That is the environment we find ourselves in today.

Exhibit 1: Global stock returns positively skewed if earnings estimates are rising

Our view for 2024 is that equities will rise to all-time highs even without a meaningful decline in bond yields. Embedded in this thesis is the view that the relationship between equity multiples and bond yields is not mechanical or stable, but rather changes over time.

In theory, higher rates of return on safer assets like bonds and cash can create valuation pressure for equities. But in practice, recent data indicates that bond yields and equity valuations are currently where they are for the same reason: a medium-term growth outlook that we believe is better than it has been for the past 15 years, if not longer.

The equity risk premium – or difference between the expected earnings yield on stocks and the 10-year US Treasury yield – was more compressed before the global financial crisis of 2007-2008 than afterwards, when yields and nominal growth were much lower.

Earnings growth has been a good guide as to whether equity indexes will go up or down over the tactical time horizon of up to one year, while valuations are not. Over the past 25 years there has been no relationship between valuations and forward one-year returns for US stocks.

At the index level, global equities are undoubtedly expensive relative to history. However, elevated valuations are more concentrated in select pockets of the market, particularly US technology companies, rather than widely dispersed. And in our view, these more richly valued areas are expensive for a good reason. It is not just based upon expectations of future profit growth, but also a recent track record of delivering substantially better bottom-line performance than the rest of the investment universe at large. Such periods of operational outperformance can persist for a long period of time.

Prior to the pandemic, for instance, internet platform companies were able to post more consistent and robust profit growth than the rest of the market, which helped to explain their superior returns over the course of an entire economic cycle.

Similarly, many current market leaders are expanding earnings well above the market pace, which we expect to continue. Artificial intelligence, in our view, is the type of catalyst that can power an extended period of earnings and market outperformance for certain industries and companies. As such, we maintain exposure to that theme – and by extension, US stocks in general.

Valuation is and will remain an important tool when evaluating investment opportunities. But in our view, macroeconomic conditions are what will typically dominate market movements over the tactical investing horizon. Right now, the macro backdrop is strong.

This environment should be supportive of continued gains in global stocks and a broadening out of the equity rally as the outlook for earnings is improving and positioning is not stretched.

We do not see signs of euphoria in equity markets. Measures of positioning have normalized over the past three months, but have not ascended to levels that imply an elevated near-term risk of a meaningful drawdown. And we have yet to see an exodus from the nearly USD 6 trillion in money market funds into riskier assets.

In our view, yields on government debt are likely to remain rangebound, with subdued bond volatility supporting risk assets.

To be sure, valuation plays a crucial role in our strategic asset allocation decisions on how to best structure portfolios for the long term. And even though valuations are not a good guide to how equities perform directionally in the short term, Exhibit 1 also shows that high multiples can be a reason to expect lower – but still positive – future returns, as long as earnings expectations are rising.

In addition, valuation is useful in assessing when there is upside asymmetry. When an asset has reached multi-year lows in both price and valuation, it can often be a sign that selling pressure has been exhausted and the risk-reward proposition has improved on a tactical basis. But the same holds true in the opposite direction: because equities are expensive at the index level, there is more potential downside in the event of an unexpected shock.