Today’s elevated equity valuations may raise correction risk, but can also be justified by the macro recovery and policy support.
Investors in the US stock market are finding their investments at a pivotal point. On the one side, there is the fear of inflation, rising yield, taxes, and high valuation, while on the other side, the US economy is increasingly showing signs of recovery. With the growth of the US economy looking promising ahead, the decision-making may not be as easy as it looks for equity investors.
For long-term investors, these factors may even-out and may not pose any risk to the portfolio but the immediate term challenges remain. John Tousley, CFA, Global Head of Market Strategy, Strategic Advisory Solutions, Goldman Sachs Asset Management in the GSAM Connect note highlights ‘Four Challenges for Investors Today’ – Taxes, Rates, Inflation and Prices. Tousley, in the report, says, “We think investors should build a strategic, front-footed approach to today’s market environment.”
According to Tousley – Firmer price measures have been influenced recently by transitory factors related to COVID-19, including low base effects and supply disruptions. As these temporary pressures roll-off, we expect Core Personal Consumption Expenditure (PCE) to remain approximately near 2 per cent as the statistical composition of inflation measurements limits sustained breakouts.
Upside risks include faster-than-expected full employment, pent-up household consumption, and high fiscal multipliers from infrastructure spending.
But ultimately, we think that despite higher levels, prices will remain supportive of risk assets and are unlikely to pull Federal Reserve policy forward.
If we were to see inflation move sustainably higher, real assets may continue to outperform. We see strong potential in real estate and commodity markets especially, as they have both suffered from structural underinvestment in capex and supply over the past few years, and are meeting an influx in demand.
But equities have also historically done well in inflationary environments, ultimately beating inflation 100% of the time when held for 15 years or more. Equities with high beta to the economic recovery and to commodity prices may do especially well, including those in emerging markets.
On the high valuations that stocks are at today thus carrying higher risks, Tousley says – Today’s elevated equity valuations may raise correction risk, but can also be justified by the macro recovery and policy support. Absent renewed recessionary factors, we do not expect any sharp re-pricing of risk assets, and would-be buyers of any short term weakness.
Importantly, we find strong statistical support that equities can stay expensive for extended periods of time, particularly with relatively low rates and high corporate profitability. For example, the S&P 500 has traded at top quintile cyclically-adjusted the price-to-earnings ratio for the last ten years, and returned more than 250% in that period. Moreover, economic expansions have historically been good for equity markets, with positive returns nearly 90% of the time.