Is gradualism a cause for concern?

Thought of the day

December’s Bank For International Settlements (BIS) quarterly review sparked alarmist headlines on 4 December. The report refers to “frothy” equity valuations, continued easing in US financial conditions despite Federal Reserve tightening and the uncertainty over the end point for bond yields once rates have normalized.

But a closer examination of the underlying report supports a less pessimistic reading for global investors:

  • The BIS cites the cyclically adjusted price to earnings ratios (CAPE) for US equities, which is currently 25% above the post-1982 average. The report also shows that on the same measure European and UK equities are in line with their long-term average, and Japanese equities trade at less than half. And relative to bonds the BIS says US equities don’t appear expensive.
  • The end-point for long-term yields is uncertain, but likely to be lower than in the past. The BIS highlights that the Fed’s balance sheet will remain far larger than pre-crisis levels. (Also, in our view, US trend growth and hence the neutral real interest rate are structurally lower than before.)
  • Easing financial conditions are not alarming. The BIS suggests gradualism and predictability may have contributed to the easing of financial conditions by reducing perceived downside risks, which may have compressed risk premia.

So we take the report as a reminder of the importance of evaluating risk, rather than a cause for investor anxiety. We believe the withdrawal of monetary accommodation will continue to be gradual and will not unsettle global equities, where we remain overweight.

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