Following the geopolitical-induced bout of volatility last week and apparent de-escalation of the conflict between the United States and Iran, investors can now re-orientate their focus to fundamentals as the fourth quarter reporting season gets underway. While earnings probably stabilised and started to re-accelerate in the final quarter of 2019, the rally in price suggests that equities have incorporated much of the improvement (chart 1). Consensus EPS is expected to rise by more than 10% in 2020 after contracting in the third quarter of last year. The good news is that a range of cyclical sectors in EM and Asia have not priced in the recovery. That is the focus of our attention.
Of course, valuation is also a function of interest rates and liquidity which drive the risk premium. As we have noted over the past few weeks the key development on that front has been the (now well appreciated) policy easing last year (both rate cuts and balance sheet expansion) and the high hurdle rate for future policy normalization or tightening. Of course this prevailing bias has been a contributing factor to the rally since October last year.
From our perch it is often interesting to estimate the “implied” P/E from the investment grade corporate bond yield. On this basis, the current P/E of the S&P500 does not look particularly stretched compared to the current level of interest rates or corporate credit. That is, although the P/E is one standard deviation above the 30 year average, the level of interest rates suggests that it ought to be quite a bit higher. This exercise also highlights just how extreme the valuation multiple was in December 1999 (chart 2). Not only was the valuation multiple at an extreme level, interest rates were materially higher implying that the warranted P/E was a lot lower. However, the key point today is that although the valuation multiple is elevated, the warranted P/E based on interest rates is probably a lot higher.
The final (and related) point to note is that the direct impact of lower rates for companies is the decline in interest as a percent of sales. Over the past 10 years, interest as a percent of sales has averaged 2.1% compared to 4.4% in the pre-crisis period. Second, the corporate tax cuts at the end of 2018 lowered the aggregate tax rate for US companies to 19.9% from 26.3% in 2017. The tax rate is only expected to increase marginally in 2020 to 21%. Profit margins outside of the technology sector are expected to remain relatively stable, with tech margins to expected to expand further. Looking forward, the key risk to profit margins would be a further tightening in the labour market or from a structural shift in the balance between capital and labour. That could be a key risk or implication of a progressive democratic win later this year.
In conclusion, while the US stock market appears stretched based on the P/E valuation multiple, the warranted P/E based on the level of interest rates is quite a bit higher. Nevertheless, the opportunity in sectors sensitive to global growth outside the United States, specifically in Asia and Japan, appear more compelling from here.