Now that this Brexit-related distortion has died down somewhat, perhaps now is a good opportunity to refocus on a more fundamental assessment of where markets are – at least, as much of a fundamental analysis as is possible when accommodative monetary policy continues. Certainly by historical standards they remain expensive – some have commented that markets, particularly the US, haven’t been this overvalued since the tech bubble burst. And because they are expensive, markets will remain prone to bouts of weakness as investors take profit in anticipation of a major correction – as we have seen over the past month – before piling back in as such fears temporarily recede.
However, a recent paper from Capital Economics – one of the few firms which took a sanguine view of the economic effects of Brexit – argues that high asset prices will not necessarily lead to sharp price falls because equilibrium asset valuations have also risen to reflect lower equilibrium real interest rates which, given sluggish global economic growth, will remain the norm for the foreseeable future. As the term implies, equilibrium valuations imply a stock market is in balance, with its earnings yield equalling investors’ required real return on equities. And as Capital Economics points out, the current US earnings yield of around 4.5 per cent – 1.5 per cent risk-free and 3 per cent equity premium – is in reciprocal terms similarly priced to the market’s cyclically-adjusted level of 27.
While that may come as a small crumb of comfort, it does imply that like interest rates, returns on equity will also be squeezed in the months ahead – it is common sense; if you pay more for an asset, the lower your returns will almost certainly be. And it does not take into account any unexpected eventuality that could shake markets out of their monetary policy-induced slumber. Indeed, if the UK’s referendum was able to cause such a panic, imagine what the election of such a divisive figure as Donald Trump may do. The current equilibrium looks very fragile indeed.
