U.S. Equity Valuations: To Be Dismissed?

History shows that valuations don’t matter until they do. The challenge is gauging what will cause investors to balk at current multiples, which have vaulted to elevated levels.


Monetary policy uncertainty is a potential candidate: reduced domestic liquidity would force profits, which have entered a difficult phase, to become the primary driver of capital appreciation.
A dearth of pricing power, rising wage expenses and a strong U.S. dollar together put a serious dent in earnings growth projections. The strong dollar on its own is a tactical valuation warning. The narrowing yield curve is another signal that the market is not comfortable with the Fed’s judgment that the economy can handle and even needs higher interest rates, another threat to valuations.
A number of other factors could still cause valuations to reset. Economic data is undershooting expectations in the U.S., even though momentum has picked up abroad. This reinforces that foreign QE programs are redistributing growth via currency weakness rather than lifting global final demand in aggregate. The forward P/E and economic surprises have also trended together since the Great Recession.
The market has ignored the recent downturn in inflation expectations. The latter is an excellent indication for S&P 500 sales, and by extension, corporate profit growth. The gap that existed since 2013 can be explained by QE, i.e. investors were content to overlook deflation threats because the liquidity taps were still gushing. But now that the Fed is telegraphing a path to tighten, it is possible that the gap will close.

QEs And EM: A Love-Hate Story

Has quantitative easing (QE) among developed nations’ central banks benefited emerging markets (EM)? While it seems very intuitive to answer “yes,” our EM strategists believe the interaction between G7 QEs and EM financial markets and economies has been much more complicated. In fact, this relationship resembles a love-hate story.


On one hand, G7 QEs has depressed yields on their local domestic fixed-income securities, encouraging global investors’ “love” toward EM. Consequently, substantial capital has flown from the G7 into EM. On the other hand, EM risk assets – stocks, currencies and credit markets – have performed very poorly, despite ongoing and rotating QEs within the advanced countries.

Many investors have been disappointed by EM’s broad-based poor performance. As for EM policymakers, back in 2009-’10 they struggled to contain massive portfolio inflows. Now, a number of them are struggling with outflows. Both issues – investors’ disappointments with EM asset performance and EM policymakers’ travails managing the torrential inflows/outflows – reflect the “hate” aspect of the interactions between QEs and EM.

The reason why EM risk assets have done poorly despite the ongoing QEs is their indigent fundamentals in general and sharply deteriorated return on capital. Capital inflows related to QE led to overinvestment and mal-investment in EM, which is now weighing on profitability.

By and large, odds are low that the ECB’s QE will be very different from the previous QEs with respect to its impact on EM; it could produce short-term bounces in EM, but the cyclical outlook for EM risk assets remains downbeat.

Dollar, Oil And U.S. Investment Strategy

Currency and commodity markets are having overdue technical countertrend moves after moving a long way in a short period of time. “One-way bets” are over. Price moves in the other direction will be violent given the crowded nature of these trades, but, according to our U.S. investment strategists they will not prove sustainable.


The trade-weighted dollar and crude oil prices exhibit all the signs of major technical extremes. Spot prices are far away from moving averages. Intermediate-term momentum indicators have been stretched for several weeks. Trading sentiment is lopsidedly optimistic on the dollar and equally pessimistic on oil. Speculators are long the dollar, although oil positioning is less clear owing to lack of speculative positioning data for Brent futures prices. Nevertheless, oil market open interest remains high even after the recent bloodbath. Market-positioning extremes on this order of magnitude suggest that these trends are overdue for at least a pause. However, they do not provide insights into whether the underlying trends are reversing.

For the dollar, relative monetary conditions between the U.S. and the rest of the world continue to diverge. Fed hawks and doves still have a mid-2015 rate hike in their sights. In contrast, rate cuts and QE are the default setting in most other developed and emerging countries, with rare exceptions like Brazil. Policymaker attitudes towards their currencies also continue to diverge. Fed officials emphasize the transitory nature of the strong dollar’s impact, while Abenomics in Japan has a weaker yen as an unofficial target.

For oil, prices may not have much more downside, but we expect more volatility than price recovery.

It’s All About The Yield Now

Even more of the global bond market will fall into negative yield territory, galvanizing the intense search for positive returns. The implication is that the traditional framework for projecting relative returns across sovereign bond markets based on the economic and policy outlook has been greatly diminished for the time being. Bond investing has come down to a blind, desperate search for income.


Eurozone bonds outperformed Treasurys and the global hedged benchmark overall on the announcement of the ECB’s QE program. However, we still believe that ECB asset purchases will favor higher-yielding bonds outside the Eurozone more than it will favor Bunds. As negative nominal yields extend out the Bund curve, investors will be under increasing pressure to flee financial repression. Thus, there will be pressure for long-term global yields to converge toward a low level, independent of the relative economic dynamics.


Following this logic, last week our Global fixed income strategists upgraded Treasurys and Canadian bonds to overweight at the expense of Eurozone bonds, which was moved to underweight. Gilts were left at overweight versus the global hedged bond benchmark. The table above highlights that the U.S. market is a relatively high-yielder in currency-hedged terms. The European periphery, gilts and, to a lesser extent, Canadian bonds also stand out.

In unhedged terms, the U.S. 10-year bond is even more attractive, given its high yield and positive dollar trends.

Euro Area Growth: Current Consensus Is Too Low

Regardless of the ECB’s actions last week, four forces are coming together that will lift euro area growth over the next two years to a level that is well above the current consensus of 1.1% for 2015, and 1.6% for 2016.


  • Diminished Fiscal Drag: given the improvement in structural budget balances, the need for additional austerity measures has diminished. As a consequence, the contribution of government spending to real GDP growth in the euro area as a whole should increase from 0.1% in 2013-14 to around 0.5 percentage points over the next two years. The peripheral countries should see a growth boost of around one percentage point.
  • Lower Oil Prices: The euro price of oil has fallen by almost 50% since last summer. Granted, the forward curve implies that about a quarter of this decline will be unwound over the next two years. Nevertheless, even taking this into account, the IMF estimates that lower oil prices will boost euro area GDP by around 0.9% relative to a baseline where oil prices had stayed elevated.

A weaker euro and a swing from negative to modestly positive credit growth will also propel euro area growth.