The US equity market indexes have been breaching all-time highs, yet economic data has been generally weaker and bond markets expect lower interest rates. At first sight, it appears that there is a disconnect between economics and bonds relative to equity markets. So, is it right to invest in equity markets now?
Surveys suggest that cash positions in portfolios are high and investment managers have been holding back on investing. International investors have largely avoided the UK equity market due to the uncertainty surrounding Brexit. However, with a dividend yield of 4.8% and a price-to-earnings ratio of around 12x, it looks cheap relative to gilts and other developed markets. The UK is likely to remain cheap until the fog of Brexit clears. To put this into context, the US market, with a price-to-earnings ratio on the S&P 500 of 19.6x and a dividend yield of just 1.9%, is the market most often seen as expensive.
The average price-to-earnings ratio since 1990 for the S&P 500 is 19.5x, so 19.6x is only just on the expensive side of this measure. However, profit margins are high at 10.1%, against an average of just 6.7% over the same period. If margins come under pressure, earnings may fall, and as a result, the index may look more expensive, unless of course the underlying price falls. What is of concern to investors is that, with low unemployment, wages have been rising faster than inflation. This puts pressure on margins unless employers can pass the cost through by raising prices. Thus, low unemployment and rising wages, whilst good for the consumer and the wider economy, may be bad for share prices.
Companies with stable or growing earnings, low wage costs and barriers to entry should be able to better protect margins, relatively more so than others. In addition, the trade war between the US and China appears to be having an adverse effect on the US economy. Capital investment, which had been expected to pick-up following the tax cuts last year, has failed to materialise, and the survey data, while not yet indicating a contraction in the economy, has indicated that growth may slow sharply. As a result, the Federal Reserve is now expected to reduce interest rates, starting later this month, supporting bond prices with 10-year treasury yields falling below 2%.
The value of any equity or bond can be derived from the present value of its future cash flows, adjusted to reflect the risk of receipt for each of the cash flows. The present value of any cash, to be received in the future, can be calculated using a long-term interest rate. As an example, we could use the 30-year US treasury yield to do this. The yield on 30-year treasuries is now 2.5%, down from an average of 5.0% since 1990. If we invert the price-to-earnings ratio, the average earnings yield has been around 5.2% since 1990, very close to the 5.0% average yield for 30-year treasuries. Given the greater risk inherent in equity markets and the uncertainty of future earnings, it would not be unreasonable to expect a higher earnings yield from equities than treasuries. However, this earnings yield also reflects the potential growth rate in earnings, and hence this will offset the higher expected yield relative to treasuries. The prospective price-to-earnings ratio for this year is 17.8x, implying an earnings yield of 5.8% and a premium of 3.3% on the long-term treasury yield. If earnings remain at their current levels and the relationship between earnings and treasury yields return to their long-run averages, this would imply a price-to-earnings ratio of 40x, and a doubling of the price of the US equity market. However, in a low growth, low inflation environment, earnings are unlikely to see as rapid growth as we have seen over the last 30 years. Thus, growth expectations are unlikely to fully offset the risks of higher volatility, so this upside may be exaggerated, but does allow for some of the potential short-term risks.
If we apply the same calculation to the UK market, we would observe a prospective price-to-earnings ratio of just 13.2x and a dividend yield of 4.8%. This is still very cheap relative to 30-year gilts, yielding just 1.29%. We cannot predict the exact outcome of Brexit, but once this uncertainty recedes, the UK market, which is dominated by international companies, will look very cheap in comparison to other developed markets. For those worried about Brexit who are sitting on the sidelines; cash in bank accounts is earning less than inflation and declining in real value. A no deal Brexit is likely to cause a fall in the pound, increasing overseas earnings.Leaving with a deal could see international investors return to the market, so there may be upside on any Brexit outcome.
We continue to see value in equity markets, despite present levels. However, we should caution that sentiment can be fickle and as markets rise they can become subject to sharper corrections if confidence in the path of future earnings becomes dented or interest rates rise. In the long run, we continue to believe that we should look through short-term risks to long-term value, and, on this basis, we expect equities to continue to form the core of investment portfolios for many years to come.
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