Financial Markets: Déja Vu

Earlier this year our Global Investment Strategy service invoked the experience of the second half of the 1990s as the key reference point for what might happen in global financial markets. The rationale is that there are many economic and financial market parallels between today and the second half of the 1990s:

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  • Then, the U.S. economy was significantly stronger than the rest of the world. Today, a similar phenomenon is being repeated.
  • Then, the Fed was the only central bank to start hiking rates, while the Bundesbank and the Bank of Japan were either cutting rates or holding rates steady. Monetary cycles between the U.S. and the rest of world clearly diverged. This is being repeated today.
  • Back in 1997, Japan was the first major industrialized economy to fall into price deflation. Excess savings from Japan deluged world financial markets, dragging down bond yields everywhere. Today, it is the euro zone’s turn to deflate. Bund yields are rapidly converging to JGB yields.
  • In the 1990s, a strong U.S. dollar dominated world financial markets. It compressed inflation in the U.S., undercut the Fed’s tightening efforts and caused U.S. bond yields to melt, which in turn fuelled an investment boom. Stocks soared into a massive bubble, which did not top out until 2000. Commodities, oil and emerging markets were crashed by a surging dollar.

Events that have transpired during the past six months suggest this roadmap turned out to be correct: the dollar continues to strengthen on diverging monetary policy between the Fed and the rest of the world. Bond yields have come down. The U.S. stock market has made a series of new highs but oil prices have collapsed. With U.S. equity multiples having expanded, bond yields having dropped and the dollar near five-year highs, what’s next? Please see the next Insight, Outlook For 2015: An Unstable Bull Market.

On Offer: Long-Term Value In European Equities

The five favorite structural valuation metrics of our European strategists – the CAPE, price to peak earnings, price to sales, market cap to GDP, and Tobin’s Q – all give the same reassuring message. European equities are at fair value, or even slightly cheap.

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Based on this fair starting valuation, the FTSE100 and Eurostoxx should generate a 10-year nominal return of 10-12% a year, using the very close inverse relationship between the cyclically-adjusted price to earnings multiple (CAPE) and the subsequent 10-year nominal return.

True, since the 1980s, equity market earnings per share have benefited from a structural uptrend in profit margins. Such a tailwind may have added around 1.5% points a year to equity market returns. This boost will not last indefinitely, so a more prudent assumption would be that the 1.5% tailwind becomes a 1.5% headwind, lowering the prospective 10-year return to around 7% a year.

Compared to this conservative 7% prospective annual return from European equities, we know for certain that 10-year government bonds will return 2% in the U.K. and 1.7% in the euro area. Therefore, current valuations are discounting a prospective 10-year equity risk premium (ERP) of 5%.

Estimates vary for what a fair ERP should be, but in the U.K. the realized ERP over the past 40 years is around 3.5%. On this basis, Europe’s 5% equity risk premium appears attractive. It is also much greater than that available in either the U.S. or Japan.

Bottom Line: European equities are priced to generate very respectable 10-year nominal returns.