No excess economic optimism, but questions about equity valuation - Dorval's Macro Corner (February 2020)

"Adapting economic knowledge to market realities and breaking free from the tyranny of indices"
François-Xavier Chauchat
Member of the Investment Committee. Macroeconomic framework and asset allocation.
As with previous epidemics (SARS, H1N1, etc.), the coronavirus will have a temporary and reversible negative impact on the Chinese and global economy. This epidemic is emerging at a time when indicators confirm that the recessionary forces at work since spring 2018 in the global industrial sector are dissipating.

The manufacturing PMI of developed countries has been recovering slowly since last October. Car registrations have clearly rebounded in Europe in recent months, which proves that the previous decline was mainly due to supply disruptions linked to regulatory developments. Finally, worries about world trade have subsided following the signing of an agreement between the United States and China. The economic stabilization scenario therefore seems to be well in place.
The sharp rise in global stock markets since last summer has raised concerns that investors have even become too optimistic about the economic cycle. This is not our analysis. Sentiment surveys show that investors and financial analysts were actually far too pessimistic in 2018 and 2019, especially in Europe. This sentiment has now simply normalized. Long-term interest rates have also fallen, which shows some caution about the growth outlook. Finally, the rebound in cyclical stocks that started in October 2019 has fizzled, and leadership has quickly returned to defensive sectors and growth stocks.
Far from signaling an excessive enthusiasm on the global economic cycle, the recent stock market dynamics raises above all the question of equity valuation. Are we dealing with an emerging bubble, encouraged for example by the rise of ESG investing, or with a logical rerating of the equity asset class, motivated by the collapse of yields of other asset classes (bonds, real estate in big cities, etc.)? Probably a bit of both.
However, the suspicion of excess valuation concerns only a part of the market, that of growth stocks. The P/E ratio of the MSCI world growth index has reached 23, the highest since early 2002, against a historic median of 19.3 since 1994. Steller profit growth in the new economy oligopolies, the rise in profit payout rates, and the flight to quality in a world where growth is both rarer and more disruptive have undoubtedly favored this development. Compared to real yields on US Treasury bonds, the equity risk premium for growth stocks remains comfortable, which is very different from the situation that prevailed in 1999/2000. However, compared to the value compartment, whose average P/E is only 13, growth stocks have never been so expensive since the 1999/2000 bubble. This huge gap will be increasingly difficult to justify.
In our asset allocation, we have maintained a fairly high exposure to equities because we believe that the very favorable balance between economic growth and interest rates will continue to support global stock markets. But we believe that the confirmation of the cyclical recovery—once the coronavirus effect has passed—should allow a better balance of performance between growth stocks and some value segments, including small caps in Europe, cyclical stocks, and Japanese and British companies.


Download Dorval’s Macro Corner of February 2020 in PDF version here

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