The dominant effect of QE over the past several years has been to push global bond yields towards zero (and in some cases below zero) which has triggered a massive rise in asset prices while also driving an historic search for yield.
The prevailing argument among equity bulls has been that absolute valuations don’t matter because, with a risk free rate of close to zero, why should equities not be much more highly rated - why should P/Es not reach 30x or even higher? After all, a valuation derived from discounting future cash flows does approach infinity as discount rates get closer to 0%. Therefore, much of the reason that equities appear cheap versus bonds is simply a reflection of how much bond yields have fallen. In fact, according to a recent Goldman report by Peter Oppenheimer, the S&P 500 has enjoyed a 75% expansion of its P/E since 2011 while other markets have seen even more.
To be sure, absolute levels of P/E multiples have doubled since the start of the financial crisis. As depicted in the chart below, P/E ratios are at the very high end of their long-run ranges with average multiples being below the current level for about 90% of the time over the past 30 years. The longer central banking policies keep rates artificially low, the longer investors will attempt to rationalize ever increasing multiples.
That said, as Oppenheimer points out, eventually equity valuations will have to reflect a realistic assumption about long-term nominal earnings growth. Declining discount rates may boost short-term valuations expectations but if a low-rate environment ultimately drives long-term growth expectations to 0% or below then valuations will, at some point, have to reflect that new growth reality. As Goldman points out, rolling 10-year EPS growth rates have collapsed since the "great recession" and only seem to be getting worse.
One interesting way of thinking about the sustainability of the significant asset price inflation of recent years is to compare it with the inflation that we have seen in the
real economy. As Goldman notes in the chart below, since the start of QE, inflation, wages and commodity prices have been stagnant or falling while asset prices have inflated sharply, particularly in real terms.
This seems to be unsustainable in the long run. Either wages and inflation will rise in time, pushing up bond yields but forcing financial assets to de-rate, or secular stagnation will prevail, inflation and yields will stay low, but financial asset valuations will stop appreciating and returns will be lower.
This approach of using lower discount rates to justify asset price inflation while ignoring the impact on long-term growth rates is what Goldman refers to as the "Great Dilemma."
Here lies the great dilemma for investors: on the one hand, current bond yields imply that valuations can continue to rise for financial assets (as they have already done over recent years), but, on the other hand, to justify current risk free rates into the future, we should assume lower long-term growth (consistent with ‘secular stagnation’). This should cap the level of valuations close to current levels. This is why we argue that while the Long Good Buy for equities still holds - they should do well relative to bonds over the medium term - the market trajectory is likely to be flatter than experienced through 2009 to 2016.
Goldman sees four possible paths forward from here:
(1) New Goldilocks - Inflation stays low and central banks continue to keep monetary policy very loose. Bond yields remain at current (if not lower) levels, supported by stable inflation expectations and ongoing QE. Meanwhile, the political zeitgeist, together with the perceived limits of monetary policy, triggers a meaningful boost to fiscal policy and growth expectations rise. The result is a decisive break-out of equities from their range and a new bull market starts with P/E multiples moving to higher levels. High beta stocks lead the way, but the backdrop of ongoing low bond yields means that stable and low volatility top-line growth stocks continue to perform well. EM equities continue to outperform DM.
(2) Reflation - Investors have underestimated inflationary pressures. Inflation reemerges because output gaps have closed and wage inflation rises, fiscal policy helps to reflate global economies, or commodity prices start to rise again, or because of some combination of these factors. The emergence of reflationary dynamics reverses much of the deflation concern that has led to such high risk premia. But it also results in higher-than-priced US interest rates and global bond yields rise. Initially, the transition to higher bond yields is a positive one for risky assets and equities strengthen alongside higher bond yields. Cyclicals benefit from this dynamic with financials leading the way. Defensives and consumer staples (being expensive in our view and the closest ‘bond proxies’) suffer the most. The US underperforms Europe and Japan, but DM outperforms EM. However, the limit to the index upside is dependent on the pace and extent of the bond yield rise. Ultimately, anything more than a modest rise in yields would start to undermine growth expectations and equity valuations and, in time, could start to raise concerns about growth once more.
(3) Fat & Flat - This is a continuation of the theme we have seen playing out over the past year. Equities are unlikely to be driven higher by valuation but are likely to benefit from some modest profit growth and an attractive yield. In this environment, equities grind higher (driven by some modest profit growth and cash returns to shareholders) in a relatively flat range while outperforming bonds. Investors buy equities because the alternatives are unattractive. Generally, stable, defensive, low volatility growth companies outperform. The US equity market outperforms.
(4) Stagflation - This is the most bearish of the scenarios. Growth has failed to rise relative to expectations either because fiscal policy did not work or did not materialise. Meanwhile, tight labour markets result in higher wages. Profit margins are squeezed from current levels and profit growth is very weak. Higher inflation pushes bond yields higher, but there is no compensating boost to long-term real growth. Of course, even in this scenario, we are not envisaging a return to 70s-style stagflation with double-digit inflation rates. But given the low level of current implied future inflation expectations in bond markets, the chances of an upside surprise to inflation must be high; even 3%-4% inflation would be a significant shift. Without any real growth though in this scenario, cyclicals underperform and defensives and staples outperform. DM does better than EM; the US equity market outperforms.
In the end, the ability of central banks to continue to drive equity valuations higher seems to be reaching its limits. From here, either bond yields and interest rates stay at record lows and economic and profit growth continues to decline (thereby capping equity valuations), or growth and inflation surprise to the upside but bond yields adjust higher thus increasing equity discount rates (also capping valuations).
More importantly, and as we've said many times in the past, there is no end to the number of exogenous shocks that could occur over the coming months/quarters. While timing and the ultimate market impact of those shocks are difficult to asses in advance, one thing is certain, the ability of central banks to provide a safety net for asset prices in the wake of those exogenous shocks is waning.