Industry Voice sponsored by T. Rowe Price: Disparities in valuations mean that investors need to be selective about what they own. With US equity valuations sitting at relatively high levels when compared with Europe, Japan and EM, what are the implications for investors?
Disparities in global equity valuations mean that investors need to be selective about what they own. One recurring question is whether the US bull run is likely to run out of steam. At the end October 2018, US equity valuations appeared high compared with those of Europe, Japan, and emerging markets in particular.
In assessing what this means, one sometimes overlooked factor are the differing sector compositions of different markets. For example, the US has large technology, health care, and business services sectors, so it tends to sell at a higher average price/earnings (P/E) ratio than most European markets. These have smaller tech sectors and are heavily weighted with financial stocks that typically feature lower P/E multiples.
Adjusted for these differences in sector mix, relative valuations between the US and Europe don't look too far out of line with historic norms. Valuation aside, one point in Europe's favour is that it is at an earlier stage in its economic cycle than the US. Comparing US valuations with their own history, as of mid-November 2018, the S&P 500 Index was trading at roughly 15.5 times expected forward earnings, which was within range of the 20-year historical average of 15.9.
Figure 1: US equity valuations appear high
US Equity Valuations Appear High Versus Rest of World 12‑Month forward price/earnings ratios
As of October 31, 2018
Sources: FactSet Research Systems, MSCI, and T. Rowe Price. US = MSCI USA Index, Europe = MSCI Developed Europe Index, Emerging Markets (EM) = MSCI Emerging Markets Index, Japan = MSCI Japan Index.
So, relative to their own history, US equity valuations didn't appear excessively high.
Keep an eye on US earnings
One question to bear in mind is the future path of corporate earnings as the US moves into the later stages of the business cycle. While US valuations don't currently look unreasonable in historical context, they could start to look less attractive if it transpires that the market has hit its earnings growth peak. The S&P's P/E multiple of 15.5 times is based on the market's earnings expectations for the next 12 months. If those expectations are not met, today's US equity valuations may turn out to be more expensive than they look.
Emerging markets offer opportunity
As shown in the chart, EM equity valuations are lagging those of developed markets. In our view, one source of current appeal for EM assets is extremely undervalued EM currencies. History suggests that it can pay to buy EM equities and bonds when EM currencies are cheap.
Another reason to look at EMs is that structural change may have made overall valuations more attractive. Technology has become a much bigger proportion of overall EM market cap: by the end of the third quarter of 2018, tech accounted for 27% of the MSCI Emerging Markets Index, up from virtually nothing 10 years ago. This reflects not only the growth of China's technology giants, but also the rise of other high-value EM industries based on intellectual property. In other words, the opportunity set is widening and deepening.
Takeaways
While US shares are relatively expensive, we don't think they are dramatically overvalued relative to Europe, especially taking into account the differing compositions of the two markets. But investors need to keep an eye on US earnings: careful security selection is particularly important in the late stages of the business cycle. Emerging market valuations, meanwhile, look reasonable, both in light of EM growth potential, extremely undervalued currencies, and continued structural changes in the opportunity set.
Read our full 2019 outlook here.
