Equity valuations matter
Valuation measures of equities are a significant determinant of future returns, particularly in the US. The charts below look at Price/Earnings (P/E) and Equity Risk Premium (ERP) as a driver of subsequent 10-year S&P500 returns.
Interestingly, ERP explains a higher amount of subsequent returns (has a higher R squared) than P/E, indicating that it may be a better measure of valuation for equity markets. According to the regression, the current ERP of 3.9% equates to a subsequent S&P500 return of over 10% per annum for the next 10 years.
In contrast, the current relatively high PE of 22x points to a low return. We think the P/E data is somewhat skewed because the only high P/E period captured in the data was the tech boom in the early 2000’s that ended its 10-year period in the GFC, and as such saw very low returns. While we still think the absolute PE is important for a number of reasons, we attribute more weight to the ERP prediction. Long term asset class return expectations are used as an input when determining Strategic Asset Allocation. We use an average of BCA, JP Morgan and BlackRock long term asset class forecasts. For international equities these forecasts currently sit in the range 5.9% – 7.4%. A blend of the ERP and PE return predictions above, with greater weight on ERP, is supportive of that forecast range.
Policy to remain accommodative
Last week’s FOMC meeting made it clear that the Fed has no intention of raising rates through 2022. Fed Chairman Jerome Powell commented during his press conference “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates”. The Fed also remains committed to its asset purchase program. In other words, the Fed will continue to provide ample liquidity to the market, even as the economy begins to recover.
The market reaction to the Fed’s announcement was highly sensible. 10-year government bond yields fell, while gold rose strongly. The Fed’s commitment should keep real interest rates (the price of money) very depressed, but because the economy is re-opening, this very easy monetary stance is positive for growth and inflation. It increases the chances that any correction will not morph into a bear market and underscores the support for global equity markets. Despite the improving economic outlook, government bond yields have barely moved off their lows as investors have become increasingly convinced that central banks will keep rates at rock-bottom levels.
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