World equity and bond markets fell in recent weeks, and although equities have recovered somewhat since, the episode is a reminder that expensive assets are at risk as we come to the end of ultra-low yields.
The recent global sell-off in equities reflected a range of factors – some one-offs, some ongoing. Among the one-offs, the pace of equity price rises in January had simply been unsustainably fast: As just one example, the MSCI Emerging Markets Index had risen by very nearly 10% between the start of the year and January 26. Ten percent growth per month if maintained would have trebled prices in a year. Greater realism was always going to interject.
Other factors, however, are likely to remain ongoing themes for 2018. A key one has been the start of the end of ultra-low interest rates and ultra-easy liquidity. Many asset classes, and particularly equities in the U.S., had been boosted to unusually expensive valuations because their income streams were valued much more highly when interest rates were so low.
Prepare for More Bouts of Volatility
There will be ongoing reassessment throughout the year of the absolute and relative valuations of equities as bond yields rise further. Valuations got a boost from low interest rates but also contained some element of excessive risk-taking and herd behaviour.
Several surveys of fund managers, for example, had shown that they regarded equities as overvalued, but nonetheless had substantial overweights to shares as they appeared to be the only game in town.
Investors had also been notably complacent about potential setbacks. One of the best-known measures of investor volatility expectations – the VIX indicator of expected volatility for the S&P 500, often used as a “fear gauge” – had been trading at close to all-time low levels in late 2017 and early 2018.
The VIX tends to range from around 10, indicating extreme comfort with the outlook, to upwards of 70 on particularly fraught occasions, at the height of the global financial crisis, for example. It had been trading just above 10 in early January. Currently, it is trading around the 20 mark, indicating that investors, at least temporarily, are taking a more prudent view of the potential for left-field surprises.
Shaking out some of the risk and valuation excesses from global equity markets is no bad thing: Investors are getting modestly better value than previously. It has also helped that the world economy is strengthening.
Global Economic Outlook is Strong
The JP Morgan Global Manufacturing and Services PMI, or purchasing managers index, which aggregates national business PMI surveys into a global total, has started the year very strongly, stating: “The start of 2018 saw a further solid and broad-based expansion of global economic activity, with growth rising to a 40-month high.
“Output increased across the six categories of manufacturing and service sector activity tracked and in almost all the national PMI surveys available at the time of publication … Forward-looking indicators such as new orders, backlogs of work and business confidence also suggest that this solid phase of expansion will be maintained in coming months.”
The central scenario is that the strength of the world economy will deliver the sort of profit growth implicit in still quite high P/E ratios: the MSCI World Index, for example, is trading on a forward-looking P/E ratio of 15.3 times expected earnings.
Emerging markets are cheapest on 12.2 times; the eurozone, Japan, and the U.K. are on similar ratings on 13.4 times to 13.8 times; but the U.S. remains relatively expensive at 17.3 times expected profits. Equities remain vulnerable, however, to further reality checks if profits disappoint or if investors revert to their previous underestimation of potential adverse surprises.
