Submitted by Nicholas Colas of DataTrek Research
How much more can US equity valuations expand as interest rates continue to drop? An analysis of German/Japanese equities says “not at all”, even though sovereign rates there are negative. Further, S&P 500 valuation history from 2012 and 2016 (when 10-year Treasuries were below 2.0%) agrees; multiples were either lower (2012) or the same (2016) as now. Bottom line: we’re near the top of rate-driven P/E multiple revisions, and now it will be up to earnings/trade talks to propel markets higher.
It’s not just the S&P 500 hitting a new record last week: data from Bloomberg shows the dollar amount of global debt sporting negative yields broke to a new high as well. The data (link at the end of this section):
- $13 trillion of global debt now has a negative yield, assuring a nominal loss for any buyers at current levels.
- It’s not just German and Japanese sovereigns in the mix here. Austrian, French and Swedish 10-years hit new negative yield levels.
- A quarter of that $13 trillion is in the corporate debt market.
On paper, this should be fantastic for global equity valuations and also help boost US stocks:
- As yields decline, the discount rate used to value future corporate cash flows should drop as well.
- The math here is simple enough. At a 7% discount rate, for example, $100/year of cash flow is worth $1,429 ($100/0.07). Drop the risk free rate by 1.0 percentage point and the same $100/year is worth $1,667 ($100/0.06). That’s a 17% increase in value ($238) even though cash flows are unchanged.
- No coincidence, therefore, that the S&P 500 is +18% in 2019 as 10-year yields have dropped by 73 basis points from their January highs (2.78%) to now (2.06%)
The question now: “How much can negative yields help valuations from here?” We pulled a few case studies to answer that question.
Case Study #1: Japan, the country most associated with negative interest rates:
- Current 10-year JGB yield: -0.17%
- Current forward Price/Earnings ratio for the MSCI Japan Index: 12.6x
- YTD/One year return for MSCI Japan in dollar terms: +7.4%, -7.5%
Verdict: Even at near-zero/negative rates, Japan has seen both lackluster equity returns over the last year and low valuations relative to US equities (S&P 500 trading for 16.8x).
Case Study #2: Germany, the epicenter of the current global trend to negative yields:
- Current 10-year Bund yield: -0.28%
- Current forward P/E ratio for the MSCI Germany Index: 12.3x
- YTD/One year return for the MSCI German Index in dollar terms: +9.5%, -9.4%
Verdict: Same as Japan – even the recent move to negative rates has not put a fire under German equities (1-month returns -0.4%).
Case Study #3: the US in 2012 and 2016, when Treasuries saw their all-time lowest yields:
- 2012 average daily 10-year Treasury yield: 1.80%. S&P 500 total return in 2012: 15.9%. Average forward P/E ratio (per FactSet): 12.0x.
- 2016 average daily 10-year Treasury yield: 1.84% S&P 500 total return in 2016: 11.8%. Average forward P/E ratio: 16.5x.
- Worth noting; S&P 500 earnings grew by 6.0% in 2012 but just 0.5% in 2016
Verdict: the 2 years with the lowest Treasury yields saw valuations either lower (12.0x) or the same (16.5x) as today. Rates in 2012 and 2016 were modestly lower than Friday’s 2.06% close. US stocks still worked, but largely because of hopes for cyclically improving earnings.
The bottom line: there are clearly diminishing returns from ever-lower long run interest rates when it comes to how they inform equity valuations. Current valuations for German/Japanese equities show that outright negative rates do not help; both trade at sizable discounts to US stocks even though Treasuries pay much larger coupons. And when Treasury yields dip below 2.0%, as they did in 2012 and 2016, valuations don’t get much higher than today.
Why don’t yields help in the way simple valuation math says they should? We’ll wrap up with 3 ideas on this point:
- Negative rates are a sign that the transmission mechanism between monetary policy and the real economy is broken. Economic actors and market participants are therefore reluctant to spend and/or invest.
- They also signal that deflationary pressures are building, potentially reducing consumption and therefore future earnings power.
- Looking just at today’s situation, negative sovereign debt yields push capital into riskier corporate debt at a time when this asset class may already be over-stretched. In the US, for example, total corporate debt is 48% of GDP, an all time record. This “crowding in” phenomenon makes the economy more fragile and threatens earnings stability in the next downturn.
The upshot from all this: history says don’t look for multiple expansion as global rates plumb fresh lows. Equity returns - in the US and elsewhere – will have to come from earnings growth now. All that puts extra pressure on the Trump/XI meeting at the G20 meeting later this week.