We don’t think so – and would argue that the vast majority of the rally so far can be explained with improved fundamentals – only very recently have there been signs of equities re-rating on liquidity alone.
Taking US equities, which contribute more than half of the MSCI World’s market cap, as an example, we look at what have been the drivers of the 130% rally so far and whether these factors can continue to boost share prices.
More earnings
Earnings have been the biggest contributor to performance since the March 2009 trough. After falling around 40% during the financial crisis and global recession, US profits have since rebounded by 80% and are, just like share prices, at all-time highs. So the profit recovery accounts for almost two thirds of the equity rally. The profit recovery has not been uniform across the globe. In Europe, for example, profits are up a more modest 35% over the same period, but share prices are also up less.
Fewer tail risks
Most of the rest of the rally has come from a re-rating of equities, i.e. higher valuations. In the case of the US the forward PE ratio has increased from a low of 9.5x to a recent high of 14.1x, a re-rating of almost 50%.
There are, of course, many potential drivers of a rerating, including the pricing out of risk, the anticipation of accelerating earnings growth or even a re-rating in the absence of improving fundamentals, which could perhaps be described as the creation of a bubble.
We would argue the first two explanations have been the biggest contributors to the re-rating so far. Going back to the initial rise in PEs in 2009, this was no surprise: it is the typical behaviour after any large correction. As confidence on the economic trough emerges, excessive pessimism about the future path of earnings reverses and equities re-rate in anticipation of the post-recession earnings recovery.
But PEs subsequently drifted lower, often in sharp lurches as a result of increasing tail risks of another global downturn and crisis. Let’s not forget that less than a year ago financial markets seriously debated the risk of an imminent eurozone break-up, a hard landing of the Chinese economy and the US fiscal cliff. These risks may not have disappeared completely (they never do!), but now seem far less likely to materialise, so a lower risk premium (i.e. higher PEs) than last summer seem fair.
But valuations do not yet seem excessive. PEs have returned from historically low levels back to historically average levels and the US trailing PE is only about 10% above its very long-term average (since 1871).
And now liquidity
But if most of the gains so far can be attributed to fundamentals such as better earnings and fewer tail risks, the most recent leg of the rally is different. Since the start of the year US equities are up 18%, yet forward earnings have been roughly flat and given the economic environment it’s also difficult to attribute the gains to investors anticipating sharp earnings acceleration. Risks may have subsided somewhat further, but it seems a stretch to attribute the entire rally to this factor.
Instead, we interpret the gains as the first signs that the liquidity swishing around the global financial system, which has already re-rated most fixed income assets to all-time low yields, is starting to have similar effects on equities.
Can this pattern of liquidity-based re-rating continue? Of course it’s possible that global growth is about to pick up sustainably and central banks will soon begin to withdraw liquidity, in which case the lasting downside to equities from today’s market levels would be limited to the part of the rally that has been based on liquidity (i.e. a painful correction, but little lasting de-rating).
But if the status quo of limited growth and excessive liquidity continues the liquidity-based re-rating, equities could have much further to run, potentially ending with equities joining fixed income assets in a bubble, as equity yields are pulled down to narrow the gap with corporate and sovereign bond yields.
The latter is not our base case, but it is an upside risk to share prices that cannot be ignored and from today’s perspective seems more likely than the negative case of a new bear market based on a global recession. For us this means we continue to prefer equities over fixed income assets.
