Are equities attractive now?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we run different scenarios on equity pricing in the current environment.  

 

Need to know Torn between higher earnings and higher rates, the valuation of equities has been volatile over the past 12 months Investors need to remember that inflation rising faster than rates can support equities – a textbook corporate-finance situation Different scenarios show how today’s pricing is consistent with flat earnings growth and stable rates. But an earnings contraction amid elevated rates would further lower valuations

 

Vexed by valuations

Following the January rally, and the more recent market setback, investor opinion is split. Some remain convinced that the bottom of equity markets is yet to be seen. After all, central banks are doing their best to eliminate inflation by slowing down their respective economies – how can we expect higher equity markets from that perspective?

On the other hand, few investors have experienced what inflation can do to the balance sheets of corporates and how strongly it can inflate sales, earnings, dividends and, as a natural consequence, equity prices.

To better understand the difficulties investors face when trying to fairly price equities, we think it is essential to go back to the basics of equity pricing. More importantly, building scenarios around earnings growth and the evolution of rates is essential, and should help streamline expectations in the face of uncertainty.

But first, let’s delve into some corporate-finance calculus.

 

Inflation itself is not your enemy

One of the essential points economists and portfolio managers are making in this experience is how inflation can hurt fixed-income securities but inflate corporate earnings. Given that the price of equities should equate to the sum of the present value of future dividends, the connection between prices and dividends becomes clear.

With higher inflation comes higher rates, and this increases the discount rate that reduces the present value of future dividends. However, with higher inflation, it is not only the next dividend that increases in value but the whole stream of future dividends, as large caps have showed strong pricing power and are still executing large buy-backs that indirectly boost dividends further.

In this relationship between dividends, inflation and rates, it is important to understand that if rates do not rise as fast as inflation, the effect on equity valuations can be positive. When inflation increases more than rates, equity prices can rise.

Another way to illustrate this effect is to look at corporates’ capital efficiency before it is distributed to shareholders. Figure 1 shows the historical evolution of return on equity (RoE) in the S&P 500. With the strong fiscal stimulus of 2020-2021 and high inflation, that RoE has reached unprecedented highs.

On average, US corporates show a 13.5% RoE for the long term and in 2022 that number reached 20%. Corporates are profitable – there is not the shadow of a doubt here – and last year’s decline in equity valuations was simply a reflection of rates rising from zero to 5%. The effect of jumbo hikes is now likely behind us, but is it time to be bullish?

 

FIG 1. Historical evolution of return on equity in the S&P500

Source: Bloomberg, LOIM

 

Let’s do the (corporate) maths

Answering this question requires a bit of corporate maths. Using price-earnings (PE) ratios provides an interesting approach. There exists a textbook relationship between RoE, earnings growth, cost of equity (e.g. risk-free rates and the equity risk premium), price-to-book (PB) and PE ratios.

PB ratios can be obtained as a function of RoE, cost of equity and earnings growth. PE ratios can be deducted from the relationship between PB and RoE, being the ratio of the former to the latter. This approach makes it possible to develop alternative scenarios based on today’s market expectations.

We run five scenarios in which RoE reverts to its long-run trend of 13.5%:

1. 0% earnings growth and unchanged rates
2. 5% earnings growth and unchanged rates
3. 10% earnings contraction and unchanged rates
4. 20% earnings contraction and unchanged rates
5. 20% earnings contraction and a decline in rates by 1% to reflect a flight-to-safety move

The resulting PE ratios from these scenarios is presented in figure 2. Comparing each to the current forward-looking market PE provides three insights:

1. The current PE of the S&P 500 is roughly consistent with one of 0% earnings growth. At the moment, the core scenario supporting the market narrative is a flat progression of earnings which implies limited margin compression, combined with muted sales
2. Should one expect a net earnings contraction from 10% to 20%, the current PE would be far too high, with the potential for a 15% decline. This corresponds with a scenario of a recession combined with sticky inflation – hence the absence of change in rates
3. Should inflation fade and a decline in rates offset contracting earnings, today’s PE would look fair

The key conclusion is that markets are currently pricing in flat corporate earnings. Today’s PE is also consistent with a decline in earnings alongside lower rates. The most adverse scenario for markets is a contraction in earnings with no movement in rates – i.e. sticky inflation. This is the markets’ blind spot and number one risk at the moment.

In our view, this risk is not our core scenario, but its odds are undoubtedly increasing. Finally, let us not forget that equities are a claim on the nominal growth of the economy in the long run: if markets start looking through the next expected soft patch to and inflation remains high, bears could be disappointed.

 

FIG 2. Price-earnings ratio as a function of five scenarios

Source: LOIM, Bloomberg.

 

Simply put, current equity valuations are pricing in zero earnings growth and stable rates. For valuations to decline significantly, a marked recession is needed.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

• Our growth indicator declined this week, essentially with the US and Eurozone batch of surveys, mostly pointing to a deteriorating outlook
• Inflation surprises should continue to be negative across the board in the coming months, despite current data showing otherwise. From the perspective of our indicators, it is nothing but an interlude in this disinflation story
• Our monetary policy indicator has crossed the 45% threshold and remains below this level for now. In light of this, the moderation of our central bankers makes sense
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner to measure the likelihood of three macro risks – growth, inflation surprises and monetary policy surprises. The nowcasters vary between zero (low growth, low inflation surprises and dovish monetary policy) and 100% (high growth, high inflation surprises and hawkish monetary policy).

 

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