The current fixation of US equity investors on the looming interest rate increase from the US Federal Reserve, which would be its first in nine years, is a little bit like the kids in the car on summer holiday. With every mile, the increasingly urgent question to their parents is ‘are we there yet?’ are we there YET??’
It’s all eyes on the Fed until we see the first lift-off in rates in September or potentially December of this year. We know that we’ve gotten beyond the patch of weak economic data earlier this year and are returning to stronger growth, as signalled by the healthy labour market data in recent months. Ironically the marginal uptick in the US unemployment rates is actually a positive indicator, in that it suggests more workers are motivated to rejoin the job search as the economy gets brighter. The big question is whether the Fed will feel comfortable enough with the resilience of the underlying US economy to begin the path towards normalisation.
Throughout this recovery we’ve longed to see much more robust GDP growth, although it’s important to note that the modest growth that we’ve seen so far hasn’t held back the magnitude or longevity of the six year strong bull market. Similar to operating a car with a manual gear shift, we’ve never been able to get into 5th or 6th gear, seemingly always puttering along in 1st or 2nd gear. This lack of runaway growth so far suggests that we’re only in the middle of the business cycle, rather than towards the end. In other words, if this is a much longer economic cycle than we’ve historically been used to experiencing, then it’s likely we have a lot farther to go on the upside, even if we only get there gradually.
The context hasn’t changed much for looking at whether US equities are too expensive. Doubts persist about whether they have reached the top of their potential, with the uncertainty about the timing of the Fed interest rate hike acting as another reason for investors to consider taking money off the table. They should think again.
We don’t claim that this market looks inexpensive following several years of spectacular gains, but there are some significant reasons why valuations alone are not valid signs that investors should be taking profits or expecting a correction.
For example, many investors cite the current price to earnings (P/E) ratio on US equities looking stretched as a reason to bail out of the asset class. But let’s look a little closer. Even after returns of more than 200% since the financial crisis, we’re currently on 17x P/E, which is about fair value. It doesn’t feel cheap, but the market isn’t demanding. We say that because if we look at the history of 12 months returns after forward 1 year earnings multiples, as shown in the chart below, we can see the average annualised return in the next 3 years when the market is on 17x is 16.9% and over 5 years it’s 9% annualised. It is not until the market gets to more than 20x that future returns begin to look challenged.
There is reason to believe that stronger US earnings growth will continue to support the market at these levels. In fact, our analysts predict average 4% earnings growth this year (11% if you strip out the energy sector, which is impacted by lower oil prices). Therefore, we don’t necessarily agree that US equity valuations look overly stretched.
We also need to consider the lessons of history when it comes to bear markets. If we define a bear market correction as a fall of 20% or more, we can look back to see that the S+P 500 has had 10 bear markets since 1926. 8 of these 10 bear markets were caused by economic recessions or commodity shocks. Extreme valuations were a contributing factor in just four of the 10 bear markets, many of which were exacerbated by other factors. In other words, valuations themselves are very rarely the cause for the beginning of a bear market.
Finally, we also challenge the notion that rising rates from the Fed could act as a negative drag on the universe of US dividend paying stocks. Research in the chart below shows there is actually a positive correlation between rising interest rates and rising equity prices, when interest rates are rising from a low level. When interest rates are rising from a low base, there is a positive relationship between yield movements and equity returns on both the S+P 500 Index and the MSCI Europe Index. The markets initial reaction to an interest hike tends to be a pullback reflex, but markets then tend to revert back to a strong upward trajectory following a rate rise. Therefore, we argue that an interest rate hike in the context of a more healthy US economy is unlikely to derail shares.
The US equities bull market may be getting long in the tooth, but investors should reconsider before they rotate out of their US equities exposure. There are solid reasons to believe that the US party can continue for some time.
Fiona Harris is a US Equities Specialist at JP Morgan Asset Management