Higher equities will lead to dangerous valuations

Global equities are still bid as investors are buying into the argument that central bank easing and US-China trade deal will pull economic growth out of its slump. The Fed is agreeably becoming more aggressive, better late than never they say, but is it enough to get ahead of the curve? Our view is that the Fed’s models are not able to properly incorporate the dynamics from higher tariffs and disruptions in supply chains for US firms. Otherwise, they would not have been so complacent over the past 18 months. What goes for the US-China trade deal the probability of a grand deal is still low before the US elections next year in November. On Thursday a potential turn for the negative could start again as US Vice President Mike Pence delivers his second speech on China next Thursday. He is known for being one of the hawks against China and this speech could dilute the trade negotiations that just recently took place in Washington.

Another potential dimension to the stubbornly high equity prices and valuation is the low interest rates and increasing amount of negative yielding debt instruments. This phenomenon is forcing investors to rethink portfolio correlations and expected return profiles for asset classes. Many retail investors are buying equities because of the ‘what else is there to buy with a return?’ mantra and recent Bill Gross has been out saying investors should buy robust dividend paying stocks as a substitute for bonds. Another trend in equity markets is the demand for low volatility stocks, again working as substitutes for bonds, which has pushed US minimum volatility equities to a historically high valuation premium currently at 28% above the S&P 500 which already is valued at a 30% premium to global equities. As of September, S&P 500 valuation rose back into danger zone and this with falling profit growth.