Until recently, record-low interest rates meant that equities still represented relative value despite historically high valuations. But with front-end interest rates set to rise rapidly in the next couple of years, relative valuations are going to be an increasingly important consideration when investing, as high multiples often lead to lower future returns.
Figure 3 illustrates how valuations in Europe, as measured by the 12-month forward PE ratios, are much lower than those in the US. This is largely due to differences in the sectoral compositions of the two stock markets. Ever-lower bond yields have boosted the valuation of longer-duration equities in sectors such as technology at the expense of shorter-duration equities like value stocks over the past 10 years. The result: extremely low valuations in markets like Europe that are heavily weighted toward cyclical or traditional value industries and high valuation in technology-heavy markets like the US.
But even after adjusting for the differences in sectoral composition, valuation gaps between the two markets remain significant. This suggests that, while the US equity market should still perform well, there is more room for rising valuations, on a relative basis, outside of the US. We think that European equities offer attractive value, particularly for investors trying to reduce exposure to the most expensive areas of the market.
