UBS | Post 2008, there is evidence that real growth has slowed down on a trend basis. Long – term expectation s of inflation have also fallen globally. In the long run and beyond cyclical swings, earnings growth is also likely to decline on average from pre-crisis norms of 10-11% to ca. 6 -7% in Europe and the US (in our estimates).
But valuations have remained high regardless – is this the sign of a bubble?
Equity valuations have remained resilient, despite the decline in earnings growth prospects. There is growing concern among investors that the equity market may be complacent. Are valuations likely to decline, as investors gradually lower their expectations for earnings growth in the US and Europe?
Not necessarily: high valuations mostly due to big decline in risk -free yields.
For current valuations to make sense amid a secular decline in earnings growth, we esti mate that the “implied discount factor” for equities has likely declined by about 4% on aggregate in the US and EU. Is this excessive? No, it is the mirror image of the secular decline in bond yields. More specifically, at least 75% of the drop in the equi ties discount factor is driven by a sharp drop in long-term risk-free rates.
Low risk -free yields regime (and its impact on stocks) likely to persist.
Over the next few years risk-free yields can back up periodically. But by and large, both the low yields regime AND the valuation boost it implies for equities will likely persist. First, because low trend growth implies lower equilibrium/neutral policy rates (See Big Macro 01). Second, because large central bank balance sheets (QE) are unlikely to be wound down; the portfolio effects of QE on bonds and stocks are large and likely to persist (see Big Macro 03). Third, because global disinflationary pressures are unlikely to reverse soon, as we will be discussing in future research.
There is still some value in stocks vs bonds (dividend stocks to benefit further).
As we discuss, returns of stocks over bonds are less likely to be affected in the long run by the secular decline in nominal growth. Japan’s 40 -year experience provides evidence in this direction. Moreover, at the moment, equity market dividend yields are at historic highs compared to bond yields, investor risk aversion is not low and actual earnings growth has room to recover from suppressed levels (towards a lower trend growth rate). All -in, stocks should outperform bonds (at least in total return terms); we provide evidence that dividend stocks should continue to do well.
But expect lower total returns, a worse risk -reward and large valuation gaps.
Not all is rosy though. There is a cost to high valuations, low discount factors and slower long -term earnings growth; we provide theoretical and empirical evidence that the total returns for sto cks are likely to be lower going forward, both on an absolute and on a risk -adjusted basis. At the same time, gaps in valuations between sectors become larger and more persistent (outside recessions).
The main risk; a cyclical downturn
The sensitivity of the equity market to cyclical slowdowns is likely to be higher going forward. The closer global yields move towards zero, the lower the cushion against a growth downturn for stocks.