Global equities were significantly derated last decade, partly because stocks had hit extremely overvalued levels in the early-2000s.
Price to earnings (P/E) ratios continued to decline because of the escalation in economic pessimism and uncertainty. Yet despite the sub-par economic expansion, stocks have been gradually rerated over the past two years, and we expect higher prices to further boost valuations in 2014.
Until the last decade, equity valuations and interest rates tended to move inversely. However, in the 2000s, both moved lower. The decline in inflation and inflation expectations brought down interest rates. Moreover, central banks in the developed world are now determined to leave rates near zero until the global economic expansion is on a more solid footing.
While their goal of stimulating growth makes us mildly bearish on government bonds, we doubt that yields will rise sufficiently to become competitive with risk assets, especially stocks.
The key to higher equity valuations is for earnings expectations to improve, and for investors to have greater confidence in the sustainability of the economic expansion. Equity markets benefited from such a lift last year as the US, Japan and most of Europe underwent a simultaneous increase in economic activity for the first time in many years.
Still, investors are wary of over-optimism, given repeated negative shocks since 2007, including recent tensions in some emerging economies.
Importantly, the global return on equity has only recovered to its long-term mean, and has more upside if the strength in global leading economic indicators proves accurate for 2014. Rising commodity prices were negative for stock P/E ratios last decade (and in the 1970s), but this drag has reversed in recent years. Moreover, P/E ratios historically have risen when government debt/GDP levels decline. This condition is already evident in the US and should gradually spread to Europe as economic activity firms.
Gains in corporate earnings and the reversal of some forces holding down equity valuations bode well for stock prices. Most developed world bourses became overbought by late-2013 and gains this year may be more modest than in the past 12 to 18 months. However, we continue to recommend being long equities and underweight bonds.
Warren Smith is a partner at MRB - The Macro Research Board