What a half-year… What a rally! In fact we should say what rallies (in the plural form) as bonds and shares both made exceptional gains. MSCI equities gained 15%, whilst the global bond index increased 5.1%.
Central bankers are performing miracles. Their latest coup will allow France to borrow more and more cheaply while simultaneously extending the duration of its debt. That the French state should be paying negative rates to borrow over 10 years (-0.13%) is nothing short of miraculous. “Borrow more and pay less” is no longer an impossibility but embedded in the curve – the kind of slope you would normally only dream of. The EUR 2,500 billion of French debt outstanding (approximately the same as the country’s GDP) is costing the government just EUR 37 billion. Debt in the 2000s was lower but cost nearly 6% of GDP. Mario Draghi is getting ready to retire. We salute him. He has done a lot for us.
Turning to the more humdrum matters of market value, the surge over the past half-year has shown that there is an inverse correlation between the multiples paid on a share and interest rates. This said, low interest rates have other non-value impacts on equity markets, the most significant being a radical polarisation of the market. There are on the one hand “victims” (e.g. banks and cyclicals) and on the other hand what are sometimes called “stars”, which are ever more highly priced. The term “stars” is vague and deserves a closer definition: stars lie at the intersection of the four specific categories defined by our Anglo-Saxon friends: growth/quality/momentum/low vol.
In simple terms, these stars are companies with growing revenues and regularly increasing earnings and, finally, which have a recent track record of market gains and are less volatile than their indices. A few well-known examples would be LVMH, Nestlé and L’Oréal. Paying more for growth – provided it is regular – is nothing unusual. The only question is how far you should go? Nestlé is trading on a P/E of 34 compared to an average 18 for the MSCI Europe. Is this a fair premium or something to worry about?
The top quartile of growth stocks costs 25 times earnings, the bottom quartile just 12 times. How does this compare historically? We saw wider growth premiums in the 2000s but aside from this boom period, we find that growth has rarely been more expensive. Similarly, the other factors mentioned above (quality, low volatility, momentum, etc.) are also running at highs.
Rather than looking at the dotcom boom (which looked very different to the current markets) another period may be more instructive: the nifty fifty boom. Going back 50 years – to the early 1970s – the US market showed a similar degree of polarisation. Fifty stocks, which were identified as the big winners of coming decades were trading on ever higher multiples compared to the market. Towards the end of 1973, the nifty fifty’s average P/E was standing at 3 times the market average. Star names of the time amongst others included Xerox, Kodak, IBM, Coca Cola, McDonald’s, Avon, Walt Disney, Polaroid.
As Exane notes in its excellent report*, the companies’ earnings forecasts at the time proved correct over the following decade (Kodak and Polaroid only ran into problems much later). But this group of “good students” nevertheless underperformed by nearly 50% over the 5 years following their relative valuation peak in 1973. The inflation shock and strong rise in interest rates messed up their earnings premiums. This premium has never been seen since: in 1980, the average P/E of our stars was just 1.3 times the market, indicating a brutal fall from their 3 times the market average peak.
High rates and inflationary shocks… We seem to have little in common with the 1970s. The nifty fifty era seems a million miles away from the current era of negative rates and rock-bottom inflationary expectations. However, beyond nostalgia for fallen giants (the sound of taking a Polaroid and flapping it around to speed up the drying) the nifty fifty also remind us that it is not enough to correctly forecast companies’ earnings to be a successful investor. Valuation multiples are key. The premium on today’s stars remains a vital question.
In absolute terms, the multiples paid for Nestlé or LVMH don’t look like a bubble. This is the reassuring part of the story. In contrast, the enthusiasm for these classes of stock (quality, low vol, etc.) is a consequence of the rock-bottom interest rate environment and is highly atypical. The more troubling part of the answer needs to be kept in mind. If the certain future laid out by central bankers starts to looks less certain and the rate environment changes, the above mentioned valuation premiums are likely to shrink, with the relative price of stars eroding. Given the Fed’s recent comments, this scenario is unlikely to overshadow the summer holidays, but it should be kept at the back of one’s mind.
* Source: Exane. The nifty fifty vs. the shifty fifty. July 2019
The views and statements contained herein are those of Marc Craquelin as at 15/07/2019.