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Macroeconomics

13 November 2019

VALUATION AND FUTURE RETURNS 

As US equity markets went from record to record over the past few weeks, the markets in the rest of the world (RoW) more or less managed to keep up.

But that has not been the case for the stats year-to-date, or even for a much longer period. This has obviously been reflected, notwithstanding superior earnings growth in the US, in widening valuation multiples. Recent research has shown that the price earnings differential between the US equity market and the MSCI World ex USA is 20%, which is about the biggest gap since 2010. Compare Europe to the US and you come to the same conclusion. The discount for the price-to-book multiple for the MSCI Europe versus the US is about 50%, a 30-year low, and well below the 28% percent median discount.

For sure, outside the US, countries in the emerging market universe have been rife with the occasional debt crash, or political coup, and in Europe cohesion has been hard to find. With Brexit increasingly imminent, the EU looks to be falling apart. At least to investors outside the EU. However, as we move towards 2020, an election year, politics should also start to play a major role. According to research from Goldman Sachs, there is already an inverse correlation between the relative performance of US pharma and the implied probability of either Sanders or Warren gaining the Democratic presidential nomination.

Politics aside, future equity market returns depend upon a multitude of factors. Those are dividend yields, EPS growth, multiple expansion or contraction and, depending on which continent you’re investing in, the currency impact. Increasingly, economists and analysts believe the greenback will depreciate next year. While this remains to be seen, the aforementioned elements also point to a less enticing picture for US stocks compared to other regions. In a recent report, Oxford Economics, a UK-based think tank, believes that in dollar terms, the US will be the worst market to invest in over the next five years. That comes mainly on the back of multiple compression as the Price Earnings Ratio slides. They expect 5% annualized returns over the next five years. They see the UK just above 10%, while the eurozone sits around 8%. Coming back to local currency per market, there is less difference between the markets, although the winners would be the UK and Australia. The US is still the laggard. However, this might not be the first time the US has been forecast to lag other markets. But if the rule that the more expensive the market, the lower future returns, applies, then you should not overweight the US market going into 2020. One remark though, when applying same sector weights as in the US to, say, Europe, valuation differentials would crumble. In other words, there are always two sides to the story.