US equities, which constitute a $25trn market, have had a very volatile past few weeks, with Central bankers meeting at the Jackson Hole Symposium, geopolitical tensions regarding North Korea, and the US GDP & labour market data releases. The Dow Jones and S&P 500 indexes have recurrently gained and lost value to an extent where no short-term trend is evident. This is all very normal when one considers day-by-day fluctuations of equity markets.
But what is the long-term outlook for US equities? Looking back, after Trump won the election in the November of 2016, several equity indexes hit all time highs due to Trump’s promises of tax cuts, infrastructure spending, and the expected business friendly environment under a republican controlled congress. Some very prominent movers of the indexes were banks such as Goldman Sachs and JP Morgan, who were expected to benefit from the lower regulations that the Republicans advocated.
Note the strong sustained increase since Trump’s election victory in November 2016
- Interest rates
- Overvaluation of US stocks
balance sheet stands at $4.5trn
What is the outlook for interest rates in the US? After the financial crisis, many central banks undertook large scale quantitative easing by purchasing government securities, in efforts to increase money supply and reduce interest rates. This was intended to stimulate the economy by increasing lending and liquidity. As of July 2017, the Federal Reserve’s balance sheet stands at $4.5tn, with $2.5tn of US treasuries and $1.8tn of mortgage backed securities being two of the largest constituents. However, the Fed is now looking to reduce its balance sheets, with most of the benefits of quantitative easing having supposedly being reaped, and with solid economic recovery taking place. Despite the most recent job growth data being somewhat weaker than expected, there is very sound economic growth taking place at 3% at a low unemployment rate of 4.4%. Generally, this would indicate an economy approaching capacity, which would induce the Fed to raise rates in order to prevent overheating.
But signals have not been so crystal clear for the Fed… Enter inflation into the equation. Rising core PCE (personal consumption expenditure) inflation is a key determinant of when to increase interest rates, with a target of 2% being a general signal to the Fed that the economy is nearing overheating. Basic economics indicates that an economy approaching capacity would mean higher inflation (see Philips Curve).
But despite the strong economic data, core PCE inflation has been below this 2% target for the last 58 months, and currently sits at 1.4%. Hence, there is some uncertainty regarding monetary policy. But some experts suggest that the Fed will still increase rates by a quarter-point in the upcoming months as they claim the low inflation isn’t due to an economic weakness, but rather due to better technology – which is improving productivity and lowering the NAIRU (non-accelerating inflation rate of unemployment). So what is the impact of rising interest rates on US equities? Well, there is a very large possibility of stock prices falling.
Impact of Rising Rates
When interest rates rise, ceteris paribus, consumer mortgage repayments rise which reduces household spending in the economy and hence reduces the earnings of a firm. On top of this, businesses face higher borrowing costs and increased debt repayments, which would reduce their growth potential and earnings. Effectively, this would reduce the future cash flows into a firm. Now, valuing a firm involves discounting the sum of all expected future cash flows back to the present, to get a net present value. Dividing this value by the number of shares will give a firm’s share price. Thus, reduced future cash flows from a rise in interest rates will reduce share prices.
If there is a synchronised reduction in the share price of many firms, it is likely that entire equity indexes will fall in value. Companies most likely to be affected are those with large amounts of debt, and those heavily reliant on borrowing for capital expenditure. Investors would feel encouraged to move funds into newly issued US treasuries after the rate hike, as the risk-free rate and yields across bonds of various maturities would rise with interest rates. Alternatively, investors may simply pull out of the US equity market in search of other regions, such as emerging market equities, which have been one of the strongest global performers with dollar-based returns of over 26%.
Overvaluation of US equities
Consider the Shiller Price/Earnings (PE) metric, developed by Yale economist Robert Shiller, winner of the Nobel Prize in Economic Sciences (2013). The Shiller PE takes the price of a stock and divides it by the average of 10 years of earnings, adjusted for inflation. We will focus on the Shiller PE ratio rather than the regular PE Ratio, as the Shiller PE eliminates fluctuations in the regular PE caused by variations of profit margins over the business cycle (upcycles would see larger earnings and hence give a lower PE, giving false signals of greater undervaluation).
Generally, a high Shiller PE value will indicate a more overvalued stock market relative to a lower Shiller PE value, as it means the market price paid for the stock (i.e. the value investors have placed on it) is too expensive when considering its earnings. Historically, bull markets have generally lead to inflated stock indexes with high Shiller PE ratios, which is generally followed by a stock market crash, as seen just before the 1929 Depression, and Black Monday of 1987, for example.
Shiller P/E for the S&P 500
It is very clear that the current Shiller PE ratio for the S&P 500, of 30.07, is reaching similar values to Black Tuesday before the 1929 depression, and far exceeds the value prior to Black Monday of 1987. Given that the mean value of the Shiller PE Ratio for the S&P 500 over the time period shown is 16.78, this is strong empirical evidence of the suggested overvaluation. Another metric pointing to overvaluation is Tobin’s q, developed by James Tobin, another winner of the Nobel price in Economic Sciences (1981).
This metric divides the market value of all US companies by the value of all the company’s assets; assessing whether the entire value is greater than its constituent parts. This metric has averaged 0.75 over its history but currently sits about 40% higher at 1.04, suggesting investors are paying overinflated prices to hold a small portion of a company. Although the past is not always a good indicator of the future, such valuations could play on investor’s philosophies and psychology and could hint at a possibility that stock prices are about to drop. In conjunction with the Fed likely to increase interest rates, the threat of a correction seems even more imminent, putting the future of US equities at risk. But why haven’t investors responded to this overvaluation yet? Would investors possibly still look to equities in such an environment?
Well, the past decade has seen historically low yields on government bonds as a result of central bank quantitative easing, and there isn’t evidence that bond yields are likely to rise significantly in the near future (any interest rate increases by the Fed are likely to be small and gradual, of about 25 basis points each time). Corporate bonds, of course, are a different story, especially risky junk ones such as Tesla’s recent $1.8bn debt issuance.
This means investors aren’t looking to government bonds as sources of good return, and are willing to take the greater risk of investing in overvalued equities. Given the low inflation and the possibility of a reduced NAIRU as discussed above, perhaps the economy is actually not that close to capacity, meaning companies do have room to continue growing and produce returns for investors. Such a prospect could greatly be enhanced for some stocks if Trump convinces Congress to raise the debt ceiling, allowing for his pro growth fiscal agenda which would be very supportive for profits and share prices of cyclical companies, despite any overvaluation.
These are very special times. Equity indexes are reaching values that have not been seen before, whilst there is low inflation in an economy supposedly approaching capacity. A lot will be clearer after Trump discusses the debt ceiling later this week, and after the Fed provides more clarity on monetary policy in its September meeting. However, given the possibility of Trump implementing his fiscal plans, and the increasing chance of contractive monetary policy, the focus is likely to turn away from investing in equity indexes, to greater investing in individual equities that are expected to benefit from both, somewhat conflicting, policies. Cyclical stocks with low amounts of debt would be expected to do well under both policies, with banks likely to see increasing profits from higher interest rates, thus pushing up their stock prices.
This is very broadly speaking however, as is it critical for investors to consider the changing correlations betweens various equities they hold, as the policy discussions advance. That being said, the overvaluation means it’s very likely for investors to reduce total portfolio weighting given to US equities, and instead look to other regions such as emerging market and European equities, or even other asset classes such as bonds and real estate. ‘Prospect theory’, heavily developed by Amos Tversky and Daniel Kahneman in the 1990’s, is very suggestive of this outlook; it says investor’s irrationality means losses are viewed more emotionally than gains of the equivalent magnitude, so investors would be more comfortable with taking risks that minimise potential losses in US equities, than to take risks that could mean positive returns.