Overvalued equities can keep rising

London: Equity valuations in the US and Europe are back to levels last seen during the emergence of the dotcom bubble and ahead of the 2008-09 financial crisis. Surely this cannot continue? A new take on the evolution of central bank policies suggests it can.

The considerable dislocations in financial markets at present are rooted in policy decisions by central banks. Since 2009, all the major central banks have switched from inflation targeting to forms of quantitative easing and zero interest rate policy.

In practice, this has involved asset price targeting. Not as a formal policy style — in any case the necessary academic framework for a fully fledged asset price targeting regime is not yet ready — but in terms of de facto seeking a wealth effect. For example, when the Federal Reserve launched QE, it explicitly targeted reflating prices of equities and related assets and pushing down short and long-term interest rates, in order to stimulate economic recovery.

However, what has implicitly been practised can in fact be described as asymmetric asset price targeting. Whereas pure asset price targeting would involve a floor and a cap on asset prices (in order to avoid boom and bust cycles), central bank QE, by contrast, just puts in a floor.

As central banks, led by the Fed, end QE and zero rates, asymmetric asset price targeting is emerging as the implicit new policy style. Implicit, in that this is not a policy style formally announced by central banks. And asymmetric, in that it continues to involve a floor but not a cap for asset prices. The targets are broadly unchanged: maintaining a wealth effect, keeping down financing costs, expanding the credit cycle, and hence boosting lacklustre economic growth.

However, just as this new policy style is emerging, so are the unintended consequences of monetary stimulus. Considerable research over the past 15 years has suggested that loosening monetary policy has a strong tendency to inflate asset prices and move economies away from equilibrium. And this is indeed the environment that prevails at present.

Excess liquidity and loose monetary policy have led to inflation not in the real economy but in the financial sphere. Since central banks have not sought to cap asset prices, US and European equity valuations have moved into excess territory.

The 12-month forward price/earnings ratio is at 16.7 for the S&P500 and 15.6 for the Euro Stoxx 600, well above historical averages (since 1988, excluding bubbles) of 14.1 and 11.7 respectively. Meanwhile, long-term interest rates have been driven below fundamental levels.

Against this background, what are the implications for investors of the new policy style? A key conclusion is that although developed market equity valuations are stretched, they could continue to rise — contrary to consensus, which is tending to neutral or underweight.

The current bullishness is built less on earnings growth, which remains low, and more on valuation expansions, which account for around four-fifths of the rise in the Stoxx 600 this year. With monetary policy supportive, assuming that economic growth matches expectations — not too hot, which would force a sharper than expected tightening of policy, and not too cold, as that would disappoint expectations — valuation expansions can continue.

Another important point is that monetary policy tightening by the Fed is likely to be drawn out, as it seeks to avoid turbulence on financial markets. We still expect the Fed’s first interest rate rise to come this year, but think it may be only one-eighth, rather than a quarter of a percentage point, as generally expected.

Finally, interest rates all along the curve should remain low for a prolonged period, as central banks seek to maintain attractive financing costs. Many investors are concerned about a crash in bond markets, but central banks will be keen to avoid this, as it would derail the economic recovery.

Instead, we expect a progressive and gradual rise in yields, rather than a sharp one, with rates on 10-year US Treasuries unlikely to exceed 3 per cent in the next couple of years. Volatility on bond markets will remain high while rates slowly converge to fundamental levels, as seen with recent spikes in German Bund yields.

Overall, the emerging new style of central bank monetary policy offers considerable comfort for investors.

Christophe Donay is head of asset allocation and macro research at Pictet Wealth Management