Jean Boivin, Head of the BlackRock Investment Institute together with Elga Bartsch, Head of Macro Research, Scott Thiel, Chief Fixed Income Strategist and Beata Harasim, Senior Investment Strategist all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Equity valuations have been top of mind after major stock indexes have scaled new highs. Last week’s volatile market moves as a result of technical deleveraging added fuel to these concerns. We do not see risk asset valuations as obviously stretched overall, and expect low interest rates – and a vaccine-led restart – to support risk assets over the next six to 12 months.
Assessing equity valuations can be difficult. Structural shifts such as persistently lower interest rates make it difficult to judge the signals from traditional metrics such as price-to-earnings ratios. The key question is whether the compensation investors are getting to take on additional equity risk, after factoring in current low interest rates, is fair. This is why we prefer to gauge valuation by looking at the expected return of equities over the risk-free rate, and our estimates for the U.S. market don’t appear stretched, as the chart above shows. This approach helps us assess valuations across different interest rate environments, yet the metric is only as good as the assumptions that go into it. Our new nominal theme suggests rates will stay low amid stronger growth and higher inflation, as central banks lean against any sharp rises in nominal rates. This should keep “real”, or inflation-adjusted yields, negative, and support risk assets, in our view. But if rates were to revert to historical averages, valuations would look a lot more stretched.
The S&P 500 Index posted its biggest one-day decline in three months last Wednesday. Large price swings in a small set of stocks that have been popular targets of short sellers led to a wave of technical deleveraging that hit the market. The dramatic rise in share prices of these stocks triggered forced selling of other equities as some investors sought to cover their short positions. Worries about market exuberance are natural in such a climate, but we believe these stock swings are isolated instances triggered by market technicals – and are the wrong thing to focus on.
The more fundamental question: have markets moved too far, too fast? Global stocks have risen 16% from a year earlier – just before the start of the global pandemic that has killed over two million and forced unprecedented activity stoppage. Tech stocks have led the charge, with the Nasdaq 100 Index up over 40%. We don’t see a disconnect – because of the nature and visibility of this shock. We view it as akin to a natural disaster followed by a rapid activity restart, and see the cumulative economic shortfall as just a fraction of that seen after the global financial crisis – an outlook markets have been quick to price in. Valuations do not look obviously stretched, as our estimate of the compensation for taking equity risk shows. The flip side: The eventual restart may not give stocks as much of a lift as past recoveries. Earnings growth will likely need to be the primary driver of returns given today’s valuations, and we see potential for a strong earnings rebound ahead.
The equity rally does have implications for longer-term returns. We now see equity valuations as fair in our long-term capital market assumptions – and expect lower returns ahead as a result. This is why we are neutral on equities over a strategic horizon. What could change the benign environment for risk assets? An unexpected rise in rates could occur if the relaxed attitude of market participants to record high public debt loads were to change – and central banks abandoned their stance of leaning against any sharp rises in nominal rates. Our new nominal theme suggests this risk is low for now, but any change in the tolerance for high debt levels could flip this dynamic in the medium term, with major market implications.
The bottom line: We do not see overall equity valuations as being stretched today, although easy financial conditions and pockets of excess could spark further bouts of volatility. We are pro-risk overall on a tactical basis, and overweight equities and credit. We favor a barbell approach in equities: quality stocks on one end to counter any hiccups caused by the slow vaccine rollout and the spread of new strains; and selected cyclicals on the other to capture the upswing led by the restart.
U.S. stocks scaled new highs before selling off briefly as large price swings in a small set of stocks that have been popular targets of short sellers lead to a wave of technical deleveraging. More than 30% of S&P 500 companies have reported fourth-quarter earnings, with over 80% beating expectations, according to Refinitiv. The Fed flagged a brighter economic outlook despite a recent soft patch and reinforced expectations for “low for long” rates, backing our new nominal theme.
This week’s U.S. nonfarm payrolls data will be in focus. Economists polled by Reuters expect an increase of 85,000 jobs, after a decrease of 140,000 in December – the first decline in eight months. The jobs report comes on the heels of the Fed policy meeting last week where policymakers downgraded the near-term outlook but upgraded the assessment further out.
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