Dear US equities …

At the time of going to press, the US equity market is a mere 1% away from all-time highs, implied volatility (VIX) is floundering close to all-time lows, and the FOMC is meeting. The monetary policy committee is set to confirm the rate hike that was clearly announced to the market before the two-week blackout.

The Fed’s about-turn may have come as a surprise: the February meeting left some doubts hanging in the air, but most committee participants hammered home the message over the space of several days that a rate hike in March was inevitable, despite the lack of economic statistics liable to shift the Fed’s core scenario in one direction or another. The FOMC may feel obliged to take a hard line in order to stem the “irrational exuberance”, as Greenspan would have called it, which seems to be emerging on risky asset markets (equity, credit).

Valuations on the S&P 500 are indeed moving further away from historical levels, particularly since Donald Trump’s election triggered greater confidence. The price to book ratio stands at 3.2x for the S&P 500, which is the highest in 13 years and twice the equivalent multiple on the Eurostoxx 300.

The forward P/E multiple (Price to Earnings) is more than 18x for the MSCI US vs. 14.2x in the Eurozone and 13.3x in emergings: we have restated these figures to remove sector bias resulting from the differing index compositions (commodities overrepresented in emergings, and financials overrepresented in Europe for example).

Admittedly, the US market has traditionally traded at pricier levels than its emerging and European counterparts due to higher EPS growth (compared to Europe) and lower cyclical and currency volatility (compared to emergings). But yet the major economic zones’ position in their respective economic cycles would usually mean that the valuation differential should be lower than the historical average: we are observing broadly negative future earnings revisions by analysts in the US, while revisions are positive in Europe and Japan.

Lastly, we can object that these P/E multiples are inflated by low long-term interest rates. The equity risk premium metric aims to eliminate this effect: it measures the additional returns expected from equities over sovereign bonds (in theory exempt from any default risk). As the expected yield from equities is deducted from earnings growth expected by equity analysts, which itself is very inertial, this risk premium is inherently cyclical (see chart page 3).

The risk premium therefore de facto reflects the market’s longterm dividend growth projections, which in theory are equal to the economy’s productivity growth. As shown by the correlation between the risk premium and productivity trend growth, the current 5.9% risk premium anticipates a return to productivity gains at 3%, which is the level we saw during the dot com boom at the end of the 1990s.

This projection looks ambitious when we remember that productivity has plummeted to 0.5% since the crisis. The market is taking a play on the possibility that the Trump years will be able to “make productivity great again”; the Fed doesn’t seem so sure.