Little evidence of widespread overvaluation in risky assets - Capital Economics
Global Markets

Little evidence of widespread overvaluation in risky assets

DM Valuations Monitor
Written by Jonas Goltermann

Despite signs of exuberance in a few markets, we don’t think that we are in the late stages of a bubble in “risky” assets generally. Provided vaccines enable the gradual relaxation of coronavirus restrictions around the world, we continue to forecast that the prices of most risky assets will rise further.

  • Despite signs of exuberance in a few markets, we don’t think that we are in the late stages of a bubble in “risky” assets generally. Provided vaccines enable the gradual relaxation of coronavirus restrictions around the world, we continue to forecast that the prices of most risky assets will rise further.
  • While risky assets have rallied a long way from their pandemic lows, there are three key reasons why we don’t think they are necessarily in a bubble. First, while the valuations of some segments of the market look high relative to those of the broader market, we don’t think that this means that risky assets generally are significantly overvalued. Second, the fact that “risk-free” rates are lower now than in the past suggests to us that the sustainable level of risky asset valuations is higher. The cyclically adjusted earnings yield of the S&P 500, for example, does not seem particularly stretched now relative to the current low level of Treasury yields, unlike before the crashes of 1929 and 2000. (See Chart 1.) Third, there is little evidence so far of the kind of leverage or financial imbalances that have been associated with the widespread overvaluation of risky assets in the past.
  • But even if we are wrong and risky assets are in fact in a bubble, this may not burst anytime soon given the outlook for the economy and monetary policy. Indeed, the rally in risky assets of the past few months has largely reflected a view, which we share, that monetary policy is likely to remain very loose for a long time even as the global economy recovers further from the coronavirus shock. So, as long as monetary policy remains accommodative, and inflation comparatively low and stable, we think that the prices and the valuations of risky assets could rise further.
  • Equities. On many metrics, valuations of developed market equities are high by historical standards.
  • Bonds. One estimate of the term premium of 10-year US Treasuries has risen, but it remains negative.
  • Currencies. Despite its recent fall, the US dollar still looks overvalued against most other G10 currencies.

Chart 1: Relative Valuations: US Equities & Treasuries

Sources: Bloomberg, Shiller, Capital Economics


Equities

  • The valuations of MSCI’s indices of developed market (DM) equities, as measured by estimated price/earnings ratios, have generally become less stretched over the past three months (2), even as equity prices have risen further. This mainly reflects upward revisions to expectations for earnings 12 months ahead (3), following the start of vaccine rollout in many developed countries.
  • Admittedly, even after the recent falls, the estimated price/earnings ratios of the major MSCI indices of DM equities remain generally high by historical standards (4), particularly in the US. And valuations also look stretched when using 12-month trailing earnings (5 & 6).
  • But we have been arguing for some time that lower-than-average interest rates justify higher-than-average price/earnings ratios and, by extension, lower-than-average earnings yields. Compared with the level of interest rates, Shiller’s cyclically adjusted earnings yield of the US stock market, for example, does not seem particularly high (7), especially given that the Fed and central banks generally are unlikely to let interest rates rise much any time soon, in our view. Other evidence also suggests that the broad US stock market is not currently in a bubble. (See Front Page and here.)

Chart 2: Price/Est. Earnings Ratios For MSCI Indices

Chart 3: Analysts’ Expectations For EPS 12 Months Ahead ($, Bloomberg)

Chart 4: Price/Est. Earnings Ratios For MSCI Indices

Chart 5: Price/Trailing Earnings Ratios For MSCI Indices

Chart 6: Price/12M Trailing Earnings Ratios For MSCI Indices

Chart 7: US Equity Earnings Yield & Long-Term Government Bond Yield (%)

Sources: Refinitiv, Bloomberg, Shiller, Capital Economics

Equity Market1 Metrics

 

Country

Change

YTD (%)2

Price/Earnings Ratio

Dividend Yield

Current

Average3

Diff. (%)

Ref: CAPE4

Current (%)

Average3 (%)

Diff. (pp)

Australia

1.7

30.3

19.8

52.8

27.3

2.7

3.5

-0.8

Austria

5.7

30.6

15.7

94.5

19.7

2.2

2.9

-0.7

Belgium

1.8

39.3

20.8

88.7

20.6

1.3

2.1

-0.8

Canada

3.7

32.2

21.5

49.8

27.0

2.2

2.4

-0.2

Denmark

-0.1

24.0

21.3

12.5

43.3

1.2

1.7

-0.6

Finland

3.1

19.3

17.2

12.5

27.1

2.6

3.8

-1.1

France

1.4

34.9

18.8

85.7

28.1

1.6

2.8

-1.2

Germany

1.9

27.6

15.0

83.8

18.1

2.0

2.6

-0.6

Ireland

1.5

28.1

19.0

48.2

33.9

0.7

1.1

-0.4

Italy

2.2

25.6

17.2

48.7

22.6

2.3

3.3

-1.0

Japan

2.9

26.7

16.2

65.0

24.2

1.7

1.9

-0.2

Netherlands

2.1

35.8

19.5

83.8

37.2

1.0

2.1

-1.2

New Zealand

1.1

32.0

19.0

68.6

36.1

2.2

3.7

-1.5

Norway

3.4

43.7

15.7

179.2

19.4

2.7

4.2

-1.5

Portugal

4.5

29.8

13.7

117.7

14.1

4.4

4.8

-0.4

Spain

2.6

33.3

16.1

106.2

20.5

3.2

3.8

-0.6

Sweden

4.5

27.6

20.3

35.8

34.0

1.5

2.8

-1.3

Switzerland

0.9

26.8

20.5

30.7

29.0

2.4

2.8

-0.4

United Kingdom

4.2

20.4

15.2

34.0

16.8

3.3

3.6

-0.3

United States

1.7

37.9

20.8

82.3

40.4

1.3

1.9

-0.7

Sources: Refinitiv, Capital Economics

Latest values are for 13th January 2021 unless otherwise noted.

1. Non-financial equity indices (local currency).

2. Total return indices.

3. 10-year harmonic averages.

4. The current cyclically adjusted price earnings ratio, which is calculated as the current price divided by the average level of earnings during the previous ten years, with all variables CPI inflation-adjusted.


Bonds

  • The term premium of 10-year US Treasuries has risen by ~40bp since the Pfizer vaccine announcement in early November, according to one estimate published by the New York Fed, although it remains negative. More than half of this rise has occurred since the Georgia runoff elections (8). The estimated risk neutral yield has fallen further, which is puzzling given that the path of short-term interest rates implied in OIS markets has risen (9). Given the Fed’s commitment to maintaining an accommodative policy stance, we don’t expect nominal yields to rise much while the economy recovers from the pandemic shock.
  • In Europe, the yield spreads of 10-year euro-zone “peripheral” government bonds over German Bunds have continued to fall and are now very close to, or at, their post-euro-zone crisis lows (10). In our view, there is still scope for spreads to fall a little further as ECB support continues to underpin the market.
  • Spreads of investment-grade (11) and high-yield corporate bond indices in major DMs have continued to edge down and are now near their post-Global Financial Crisis lows (12 & 13). We expect corporate debt to benefit from a continued hunt for yield as the global economy recovers, helping spreads narrow further.

Chart 8: Change In Components Of 10-Year US Treasury Zero Coupon Yield Since 6th Nov. (bp)

Chart 9: OIS-Implied Fed Funds Target (%)

Chart 10: 10-Year Government Bond Yield Spreads Over German Bunds (bp)

Chart 11: Option-Adjusted Spreads (OAS) Of ICE BofA ML Investment-Grade Corporate Bond Indices (bp)

Chart 12: OAS Of ICE BofA ML Investment-Grade Corporate Bond Indices (bp)

Chart 13: OAS Of ICE BofA ML High-Yield
Corporate Bond Indices (bp)

Sources: Refinitiv, Bloomberg, Federal Reserve, Capital Economics

Sovereign Bond Market Metrics

Sovereign Rating1

Datastream Index (10-Year Maturity)

Foreign Currency

Local Currency

YTD Return2

(%)

Yield

Current (%)

Average3 (%)

Diff. (bp)

Current Spread

to US (bp)

Australia

AAA

AAA

-0.7

1.12

2.84

-172

3

Austria

AA+

AA+

-0.5

-0.47

1.10

-157

-156

Belgium

AA

AA

-0.8

-0.36

1.40

-175

-144

Canada

AAA

AAA

-0.9

0.82

1.83

-101

-27

Denmark

AAA

AAA

-0.7

-0.42

0.87

-129

-151

Finland

AA+

AA+

-0.7

-0.45

0.99

-144

-154

France

AA

AA

-0.7

-0.37

1.22

-159

-145

Germany

AAA

AAA

-0.9

-0.55

0.76

-132

-164

Ireland

AA-

AA-

-0.3

-0.57

2.40

-297

-166

Italy

BBB

BBB

-0.3

0.56

2.86

-230

-53

Japan

A+

A+

0.0

0.02

0.35

-33

-107

Netherlands

AAA

AAA

-0.7

-0.54

0.98

-151

-162

New Zealand

AA

AA+

-1.9

1.12

3.14

-202

3

Norway

AAA

AAA

-1.3

1.05

1.87

-82

-4

Portugal

BBB

BBB

-0.3

0.01

4.18

-418

-108

Spain

A

A

-0.6

0.07

2.56

-249

-102

Sweden

AAA

AAA

-1.3

0.08

1.03

-95

-101

Switzerland

AAA

AAA

-0.7

-0.51

0.18

-69

-160

UK

AA

AA

-1.3

0.33

1.65

-132

-76

US

AA+

AA+

-1.8

1.09

2.16

-107

Sources: Bloomberg, Refinitiv, Capital Economics

Latest values are for 13th January 2021 unless otherwise noted.

1. Current S&P long-term ratings.

2. Total return indices.

3. 10-year arithmetic averages.


Currencies

  • The US dollar accelerated its broad decline against developed market currencies over the past three months, especially against those most strongly correlated to risky assets (14). Nonetheless, on a real trade-weighted basis it remains above its long-run average (15) and we expect that the greenback will continue to weaken gradually as the global economy continues to recover and appetite for risk remains strong.
  • The REERs of most G10 currencies other than the dollar have appreciated, and while most are still below their 10-year averages some are now above them (16). And, aside from the US dollar and sterling, most are above their 10-year trends, in some cases significantly so (17). But we think this primarily reflects a turning point in the US dollar’s trend – from appreciation over recent years to depreciation since last March – rather than overvaluation of other G10 currencies. For example, current account positions suggest that many G10 currencies remain broadly undervalued (18).
  • Finally, given our forecast that oil will outperform other commodities this year, we think that terms of trade will favour the Canadian dollar and Norwegian krone over other commodity currencies this year (19).
  • Chart 14: Changes Against US Dollar & In Real Effective Exchange Rates (Over Previous Three Months, %)

Chart 15: BIS US Dollar Narrow Real Effective Exchange Rate Index (Jan. 1994 = 100)

Chart 16: Real Effective Exchange Rates,
Deviations From 10-Year Averages (%)

Chart 17: Real Effective Exchange Rates,
Deviation From 10-Year Trends (%)

Chart 18: Current Account Balances*
(% GDP)

Chart 19: NOK & CAD Trade-Weighted Exchange Rates (Index Jan. 2017 = 100) Vs Brent Oil ($/barrel)

Sources: Bloomberg, BIS, Refinitiv, Capital Economics

Currency Market Metrics

Exchange Rate vs USD

REER1

PPP4

C/A Bal5

Current

Level

Change

YTD (%)

Diff. From Average2 (%)

Diff. From Trend3 (%)

Overvaluation Of Currency (%)

% Of GDP

Australia*

0.77

10.1

3.0

19.8

11.6

1.9

Canada

1.27

1.9

-5.2

9.2

-6.7

-1.9

Denmark

6.12

8.8

0.8

2.0

5.6

7.9

Japan

104

4.6

-6.5

8.5

-3.2

3.0

New Zealand*

0.72

6.5

5.6

10.5

1.1

-0.8

Norway

8.48

3.6

-7.5

6.7

11.7

2.2

Sweden

8.33

12.3

-3.5

10.4

3.5

0.0

Switzerland

0.89

9.1

1.4

2.0

26.8

7.6

UK*

1.36

2.9

-3.7

-0.2

-9.4

-2.1

Euro*

1.22

8.3

1.4

4.1

-16.4

0.0

Sources: Bloomberg, Refinitiv, Capital Economics

Latest values are for 13th January 2021 unless otherwise noted.

* These currencies are expressed as US dollars per currency. All other currencies are expressed as currency per dollar.

1. Real Effective Exchange Rate Index (CPI-based). An index that takes account of the amount of trade each country conducts with its trading partners, as well as different rates of inflation at home and abroad, to provide a measure of international competitiveness.

2. The REER relative to its average level of the past ten years. The more positive (negative) the difference, the more overvalued (undervalued) the currency on this metric.

3. The REER relative to the level now implied by the trend of the past ten years. The more positive (negative) the difference, the more overvalued (undervalued) the currency on this metric.

4. OECD Purchasing Power Parities (PPP) (2019). PPPs are the rates of currency conversion that eliminate the differences in price levels between countries. The column shows the current degree of overvaluation of each currency, measured by the deviation from the PPP rate. The higher the number, the more overvalued the currency on this metric.

5. Current account balance. The column shows the latest four quarter sum of the current account balance as a share of GDP.


Jonas Goltermann, Senior Markets Economist, jonas.goltermann@capitaleconomics.com
Simona Gambarini, Markets Economist, simona.gambarini@capitaleconomics.com
Jonathan Petersen, Markets Economist, jonathan.petersen@capitaleconomics.com
Adam Hoyes, Assistant Economist, adam.hoyes@capitaleconomics.com