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March 2017 | Macro Insights

Asset Allocation Views: US Valuations Aren’t Stretched


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US equities valuations are in focus after eye-catching gains since the election, and as investors consider the implications of de-regulation and other pro-growth policies of tax reform and infrastructure spending.

Regular readers of this publication or our 2017 Outlook will know that for months we have favored equities over credit and credit over rates. This is predicated on an expectation of a broadening global growth, aided by expansionary policies and potential deregulation in the US, and undemanding valuations in equities relative to bonds. However, we are calling for only moderate returns to developed market equities for the year, as balanced against those tailwinds are limited space for earnings growth, high absolute valuations and the likelihood of meaningfully higher interest rates. Here we focus on three aspects of our equity overweight: why we believe valuations are reasonable given the macro environment, how we are tactically managing our equity positioning and where we see opportunity in equity markets.

Valuations elevated, not stretched

Absolute valuations in equity markets are elevated. Multiples are high: across cyclically- or sector-adjusted PE ratios, price/book and other valuation measures the US is in its 74th percentile relative to history. Similarly, margins are high, capping earnings’ growth potential. In the US, Japan and core Eurozone margins are higher than 75% of past readings. That said, on a relative basis, low bond yields have been known to support high equity valuations such as these.

US equities are cheap to macro fundamentals


Source: Global Portfolio Solutions, as of March 2017

Instead of thinking in absolute terms, we benchmark equities to the current macroeconomic environment by considering the equity risk premium (ERP) relative to bond yields and the state of the economy (see chart). Equities can be considered cheap relative to macro fundamentals because the macro benchmarked ERP is below the market implied level. That is especially true in Europe. However, that valuation gap can close in one of two ways:

  • Equities could rally substantially, driven by either earnings growth or multiple expansion. We do not expect that.
  • Instead, we expect the gap to be closed by bond yields rising and moderate equity returns.

These macro-benchmarked valuations, coupled with expectations of rising yields and limited growth of both multiples and earnings, support our moderate overweight to equities.

Tactically managing the overweight: buying dips

We expect a more broad-based contribution to global growth this year, and a continuation of the expansionary phase of the economic cycle. Monetary policy is still easy and in regions where growth has significant room to surprise to the upside, it has. February’s Eurozone Manufacturing PMI was 55.5 and Japan’s was 53.5, both multi-year highs.

We see sources of volatility on the horizon. Near-term data could moderate relative to expectations, which are at five-year peaks. Political uncertainty has risen in the US and Europe, and China has scaled back fiscal support. According to CFTC data, investors are also increasingly long equity. However, absent a hard landing in China, our bullish view on growth gives us confidence to lean into sell-offs by ‘buying the dips’.

We are broadly overweight EM, plus select favorites

We think the balance of risks is to outperformance of emerging markets relative to developed markets over the medium term. We point to improved external balances and expected growth re-acceleration—particularly in Russia and Brazil—layered on depressed sentiment, light positioning and relatively attractive valuations. Our model of emerging market currency valuations, which adjusts for productivity, shows valuations at lows not seen since the early 2000s. Within the emerging markets universe we have specific country overweights that are shorter term, and driven by fundamentals and relative valuations. For example, we are long India as moderating inflation leaves room for potential easing from the central bank, progress on reforms is encouraging and earnings may benefit from lower energy prices.

GPS asset allocation views on a one-year horizon*


Source: GSAM Global Portfolio Solutuions (GPS). As of March 2017.
*Note that this does not account for liability-driven investment.

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