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At the time of going to press, the US equity market is
a mere 1% away from all-time highs, implied
volatility (VIX) is floundering close to all-time lows,
and the FOMC is meeting. The monetary policy
committee is set to confirm the rate hike that was
clearly announced to the market before the two-week
blackout.
The Fed’s about-turn may have come as a
surprise: the February meeting left some doubts
hanging in the air, but most committee participants
hammered home the message over the space of
several days that a rate hike in March was inevitable,
despite the lack of economic statistics liable to shift
the Fed’s core scenario in one direction or another.
The FOMC may feel obliged to take a hard line in
order to stem the “irrational exuberance”, as
Greenspan would have called it, which seems to be
emerging on risky asset markets (equity, credit).
Valuations on the S&P 500 are indeed moving further
away from historical levels, particularly since Donald
Trump’s election triggered greater confidence. The
price to book ratio stands at 3.2x for the S&P 500,
which is the highest in 13 years and twice the
equivalent multiple on the Eurostoxx 300.
The
forward P/E multiple (Price to Earnings) is more than
18x for the MSCI US vs. 14.2x in the Eurozone and
13.3x in emergings: we have restated these figures
to remove sector bias resulting from the differing
index compositions (commodities overrepresented in
emergings, and financials overrepresented in Europe
for example).
Admittedly, the US market has traditionally traded at
pricier levels than its emerging and European counterparts
due to higher EPS growth (compared to Europe) and lower
cyclical and currency volatility (compared to emergings).
But yet the major economic zones’ position in their
respective economic cycles would usually mean that the
valuation differential should be lower than the historical
average: we are observing broadly negative future
earnings revisions by analysts in the US, while revisions
are positive in Europe and Japan.
Lastly, we can object
that these P/E multiples are inflated by low long-term
interest rates. The equity risk premium metric aims to
eliminate this effect: it measures the additional returns
expected from equities over sovereign bonds (in theory
exempt from any default risk). As the expected yield from
equities is deducted from earnings growth expected by
equity analysts, which itself is very inertial, this risk
premium is inherently cyclical (see chart page 3).
The risk
premium therefore de facto reflects the market’s longterm
dividend growth projections, which in theory are
equal to the economy’s productivity growth. As shown by
the correlation between the risk premium and productivity
trend growth, the current 5.9% risk premium anticipates a
return to productivity gains at 3%, which is the level we
saw during the dot com boom at the end of the 1990s.
This projection looks ambitious when we remember that
productivity has plummeted to 0.5% since the crisis. The
market is taking a play on the possibility that the Trump
years will be able to “make productivity great again”; the
Fed doesn’t seem so sure.
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