Shares are vulnerable to a short-term correction.
But with inflation low, and as long as recession is not imminent, it makes sense that traditional valuations like PEs are higher than their long-term average.
Similarly, it makes sense that property yields are lower than normal, but the fall in Australian housing yields has been extreme relative to commercial property & shares.
Key things to watch out for are recession and much higher inflation
Share markets are at or around record levels despite lots of worries, particularly around the coronavirus (Covid-19) outbreak. A common concern is that this is because central banks (like the Fed and the RBA) are distorting market forces and just want higher asset prices. And flowing from this its argued that prices for assets like shares and property are overvalued, record highs are artificial, and a crash is inevitable. Markets are at risk of a short-term correction given the large gains since the last greater than 5% correction into August and given the risks around Covid-19. But beyond this it’s a lot more complicated than the bears would have it.
Central banks really just responding to market forces...
There is some truth to the claim that central banks want higher asset prices. Higher asset prices are part of the transmission mechanism for monetary easing to the economy because they boost wealth and this helps boost spending. As former Fed Chair Alan Greenspan said in 2010 “a stock market rally may be the best economic stimulus”. But it’s not quite that simple:
…lower inflation equals higher PEs (and lower yields)
The next chart shows the ratio of share prices to consensus expectations for earnings over the next 12 months, which is often referred to as forward PEs. As can be seen, these are now above their long-term averages in the US and Australia, although US and global PEs are still well below tech boom extremes.
Source: Thomson Reuters, AMP Capital
However, the next chart shows the long-term relationship between inflation on the horizontal axis and the price to earnings ratio on the vertical axis. The PE tends to move higher as inflation falls, although its less clear once inflation falls into deflation. And right now we have very low inflation of just below 2% globally.
Source: Bloomberg, AMP Capital
The equity risk premium remains okay
So, while share markets may be around record levels and price to earnings multiples are relatively high there is some rational for this given that it’s a low inflation and low interest rate world. And the longer inflation remains down its conceivable that the higher PEs may go. How high is impossible to know for sure. But as a result, it makes sense to look at share market valuations that allow this. The next chart subtracts the 10-year bond yield for the US and Australia from their earnings yields (using forward earnings). This basically gives a sort of proxy for the equity risk premium – the higher the better. While this gap is well down from its post GFC highs, it’s still reasonable, suggesting shares are still more attractive than bonds. Of course, this will change if bond yields rise, but as we have seen in recent years this is taking a long while to eventuate with various events including trade wars and the coronavirus outbreak conspiring to keep yields low.
Source: Thomson Reuters, AMP Capital
Basically, the same applies in relation to property and other assets in that lower inflation drives higher valuations for them too. This is evident in lower rental yields (or capitalisation rates) as lower inflation and interest rates pushes up the price relative to rents that investors are prepared to buy property at. This has certainly happened in Australian property markets with rental yields falling sharply since the 1980s and 1990s. This is particularly the case for residential property to the point that it is overvalued on some measures, with a shortage of dwellings relative to underlying demand enabling this to be perpetuated (but that’s a whole other issue beyond the scope of this note!). If the rental yield is inverted and expressed as a PE it would have risen to around 20 times for high quality commercial property but to a whopping 50 times for residential property, compared to around 12 times for both in the early 1980s and compared to around 18 times for shares. This would suggest residential property remains relatively expensive!
Source: REIA, JLL, Bloomberg, AMP Capital
So, what’s the catch?
DR SHANE OLIVER
HEAD OF INVESTMENT STRATEGY AND CHIEF ECONOMIST
About the Author
Dr Shane Oliver, Head of Investment Stratgey and Economics and Chief Economist at AMP Captial is responsible for AMP Captial's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.
THIS ARTICLE WAS RELEASE BY AMP CAPITAL 19 FEBRUARY 2020, FOR MORE AMP CAPITAL UPDATES GO TO WWW.AMPCAPITAL.COM.AU