DAILY SKETCH - Low interest rates do not justify record equity valuations

    • Daily sketch

In the financial world, there is currently a heated debate over whether record low interest rates and record low bond yields to maturity justify record P/E equity valuations. I believe that they do not justify them and that the average annual expected equities returns for the coming years are well below long-term average.

DAILY SKETCH - Low interest rates do not justify record equity valuations

Under otherwise the same conditions, of course, within discounted cash flow (DCF) models, low discount rates imply higher fundamental intrinsic equity values. At the same time, within the relative valuation metrics such as P/E, low interest rates also imply higher equilibrium, fundamentally justified, multiples under otherwise identical conditions.

However, this is only one side of the valuation coin. In absolute (DCF) and relative valuation models (P/E), the expected growth rate of dividends, earnings or cash flow also plays an equally important role. At the same time, from a historical point of view, it has always been the case that low interest rates and low bond yields to maturity have been an indicator of weak economic growth. And weak expected economic growth means nothing more than weak expected growth in dividends, earnings and cash flow.

So if we look at the other side of the valuation equation, i.e. the expected growth rate (g), I dare to say that the current very weak expected trend growth of the world economy in the coming years, partly due to the need to service record global debt and weak labor productivity dynamics, significantly reduces the equilibrium, fundamentally justified, valuation multiples of such as P/E. Therefore, I dare to say that both effects on valuations eliminate each other. Record low interest rates go against the weak expected growth.

If this view is correct, then the current record valuation multiples of global stock markets are not fundamentally justified. This would indicate that stock markets are currently overvalued. After all, we reflect this view in our global equity allocation, in which we have equities, albeit only slightly, underweighted against benchmarks.
Michal Stupavský
Investment Strategist at Conseq Investment Management, a.s.

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