While in 'normal' times the commonly held view is that P/E ratios tend to fall as real interest rates rise, as we recently pointed out here [5], the relationship is highly non-linear and nowhere is this regime-dependence more evident than in the following chart from Morgan Stanley. Empirically, the current interest-rate regime (the 2-3% 10Y) is as good as it gets and whether rates rise or fall from here, equity valuations are likely to drop. The market rarely trades at the average multiple, though the current market trades at near average levels currently (not cheap as many would like us to believe). Of course, as Morgan Stanley notes, there are a number of other drivers but on a long-term basis and top-down, equity valuations have a hard hill to climb to prove its different this time.
Whether growth slows or inflation picks up, a fall or rise in real interest rates from here infers a drop in equity market multiples...
[6]
And while many would like us to believe equities are cheap, they simply are not - they are at their average multiple over time. Most notably if one were to remove the excess euphoria from the late 90s dot-com exuberance then the current market would appear notably rich...
[7]
But of course there are a number of other factors to be considered - though many of these suggest more caution as opposed to less...
[8]
Source: Morgan Stanley
Will it be different this time and multiples will rise against empirical insight or will the equity market muddle-through along with the extend-and-pretend macro overlay that is being played out on a global central bank board. We suspect the potential for shocks, flight-to-safety, and Japanification of global interest rates (for currency issuers not users) will push valuations down and defending equity investment on the back of multiple expansion seems disingenuous at best.