Are markets accurately reflecting valuations? Morgan Stanley’s Chief Investment Officer examines two key market signals which may illuminate global equities potential this year.
Just one month into President Trump’s term, global equity markets are making new highs at a near 40% annualized rate. In fact, they are already brushing up against consensus price targets for the end of the year. Does this mean we are due for our first serious correction since last summer? Or, that upside is limited from here?
We at Morgan Stanley’s Global Investment Committee don’t think so. Instead, we think 2017 could be the best year for global equity markets since 2013.
While there is certainly a fair amount of daily noise generated by this administration and amplified by the media, our view for global equity markets is based on the cyclical upturn in the economy that began a year ago. Based on recent economic and earnings releases, we think there is 10% to 20% upside potential for global equities in the next year, driven by double-digit projected earnings growth and some valuation expansion.
To be sure, there will be some dispersion in the results. We expect the greatest earnings growth in Japan, in excess of 20%, followed by Europe, about 12%. We estimate emerging markets and the U.S. to deliver profit gains in the 8%-to-10% range. Valuations are also currently lower outside the U.S., which leaves more room for multiple expansion. Perhaps this explains why non-U.S. markets have outperformed for the year to date, led by the emerging markets, up close to 10%.
Of all the things we do as market analysts and strategists, perhaps the most difficult one is predicting valuations—what the collective market willing to pay for equity earnings rather than what it should pay.
Last month, I wrote about U.S. equities valuation because it is the number-one pushback I receive when talking about our more bullish-than-consensus outlook. Much of the analysis I shared related to what the market should pay based on earnings and interest rates.
Our call for 2017 is that investors will finally price equities closer to their fair value. This view is based on the thesis that we have moved from a post-crisis regime to something that appears to be more normal. The evidence we cite for this regime shift is evident in policy changes. In monetary policy, the U.S. Federal Reserve has ended Quantitative Easing (QE) and is raising rates, the European Central Bank is tapering its QE purchases and the Bank of Japan is targeting yields.
Fiscal policy is becoming easier as governments recognize that fiscal austerity is counterproductive when debt is high, especially when real borrowing costs are negative. This sounds reasonable, but we like to see evidence that our thesis is correct; and as readers know, I believe there is no better way to check one’s views than by observing the market itself.
Sure, prices are going up, but that could simply be animal spirits getting ahead of themselves and/or out-of-position investors taking on more risk. In fact, that is exactly the bearish argument I have been hearing from many commentators—the rally is simply a sugar high that won’t last.
However, there are other signs from the market that support the idea we have entered a new regime—one that could lead to more sustainable nominal growth and finally allow for a normalization of equity valuations. One such measure I have discussed in prior notes is market breadth, which has been very strong since the equity rally began almost a year ago. While it has weakened a little bit of late, breadth remains generally strong and leadership is coming from a broad group of sectors.
Another positive market signal is shown in the chart below which highlights cross-asset correlations—a measure of how closely prices in different assets move relative to each other.
The chart below shows cross-asset correlations before and after the financial crisis. Notice how these correlations spiked sharply after the Lehman Bros. bankruptcy in 2008 and then remained elevated during the period of extraordinary monetary policy and low growth. We saw a decline in 2013 when the Fed first hinted at tapering QE. It was also the last time we saw somewhat synchronous global growth.
Cross-Asset Correlation Has Plummeted in Recent Months
The decline in cross-asset correlations in the last six months is the market’s way of saying that we could be reaching a self-sustaining recovery that no longer requires extraordinary support. In other words, assets began trading on their own merit and were not so tied to the whims of the macro ups and downs.
Of course, in 2014 and 2015 we had a relapse in growth as oil prices imploded, China’s economy suffered a self-induced hard landing and global financial conditions tightened. Cross-asset correlations rose again as doubts about the global economy’s self-sustainability returned.
Then, in 2016, these correlations collapsed when Trump and the Republicans surprisingly won the election. Sure, the global economy was already recovering by Election Day, but many doubts still remained on whether this could be sustained, given the poor track record of every cyclical recovery since 2009. However, the potential for a change in U.S. tax policy and regulation was enough for market participants to believe that this time could really be different, particularly in the context of Brexit and other political changes already taking place.
What this means is that equity risk premiums—a measure of the additional return an asset like a stock generates above and beyond a risk-free investment such as a government treasury bond—should fall back toward normal.
The chart below shows equity risk premiums for the U.S., Japan and Europe over the past 25 years. Much like the cross-asset correlations, there was a significant increase in these equity risk premiums after the financial crisis, which makes sense.
In Our View, Equity Risk Premiums Are Likely to Decline
However, if cross-asset correlations have now come in, shouldn’t equity risk premiums fall as well? Our answer is yes, and while we have seen equity risk premiums start to decline in the past six months, there is still plenty of room for them to fall further if they are truly going to return to “normal.” Specifically, we think a return to the 80-year average seems reasonable.
If so, that would equate to an approximate 10% valuation expansion, assuming only a modest increase in interest rates—and supports our thesis that current valuations have more upside potential.
Note: This article first appeared in the February 2016 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.