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2017 will be the year of divergence. Valuations speak to that.
The US Federal Reserve has already begun its tightening cycle, albeit at a very steady pace. As a result, the dollar will rise faster than most, putting the Fed in a very tough situation: balancing domestic results versus the potential of international blowback.
The US On Top
In the developed world, the US has the loftiest valuations of any. That is not surprising given growth is more robust than most. The forward P/E sits at 16.8x, Japan 12.3x, Germany 11.7x, with Italy and Spain bringing up the rear at 11.7x and 11.2x respectively.
Although the P/E ratio is good at showcasing momentum, nothing is ever cheap, and nothing is ever expensive. The price reflects the earnings. Only if expectations are such that demand is high will the price rise faster than earnings. This is exactly what happened in the famous ‘dot com’ boom (and subsequent bust), with the price then falling because earnings simply did not justify the valuation.
Relative to their 2004-2016 average forward P/E, only the US sits above. It seems like the stock indices in America break new highs every day with the Dow Jones heading for a ridiculous 20,000 and the S&P 500 heading for 2,300. The question is, though, is there room to go higher?
Of course, such a question depends on a million factors, but economic growth is the main driver. US PMIs look solid, as does consumer confidence. What it will boil down to is the pace of the rate hiking cycle.
If Trump does manage to get his infrastructure plans into meaningful action, inflation should come through. This will force the Fed to raise rates more steeply than in their famous inaccurate dot plot.
However, even if Trump does indeed set the spending ball rolling, that does not guarantee inflation if the wages given to the workers are still flat. Sure, unemployment will fall even further but disposable income will not necessarily rise.
That said, if such economic policies are delayed for some reason, which is the likely scenario given the track record of Washington, the S&P will still steadily rise because deflation will not be the major worry due to falling corporate cash flows.
The Role Of Political Uncertainty
In other metrics like the forward P/B, the US is at 2.6x, while Japan and Spain are considerably lower at 1.0x, Germany at 1.4x, while Italy is trading below book value at 0.8x. But before you pile into Italian stocks, political uncertainty and the state of their banking system is one to watch, which could send the MIB south.
That said, the ECB would likely provide a backstop so in some sense, what is the worry? For Italy, the real factor will be whether the consumer can ignore the big headline macro factors.
Confidence is key and in January 2016, this figure stood at 118.7; it is now 107.2 and has been falling month on month. This is worrying, especially if the Five Star Movement enter the picture in a big way if they have not done so already and begin the anti-eurozone referendum hiatus.
On a pure valuation basis, the US has by far the highest valuations. However, one should not forget that such valuations are predicted on the notion of bullish expectations. US growth is about take off in a solid fashion so, as long as the domestic consumer keeps borrowing and spending, the Russell 2000 should keep rising.
Regarding the S&P on the other hand, given the strong dollar and given that 60% of the index are earnings export-led, one should be careful, not least because relative to history the index has surpassed this level never.