Creating a model that sensibly and accurately predicts and provides a solution for long-term impact of the Covid-19 crisis on risk assets is probably too complex.
Both the micro and macro uncertainties are significant. How would you sensibly model and predict corporate fundamentals such as earnings, brand longevity, indebtedness and defaults?
Equally, it is hard to estimate the economic environment in which companies will operate.
How involved will central banks be in markets; how do we resolve the debt burdens; will tax rates rise or austerity be imposed or both; will inflation go up or down; will consumers return to old spending patterns; will interest rates stay low or rise; will employment fall and will economic growth be low or even negative?
Modelling all of this would throw out too many equally plausible but incompatible scenarios, we think.
In this article, we will focus on the largest pool of risk assets of all: US equities. We will assume that we have very low odds of predicting these events, but that history offers some interesting pointers.
We ask the question: what is a sensible, even optimistic, long-term PE ratio for the US equity market?
And, given the US market now has a PE rivalling the 1999 tech bubble, we assume the current PE is hard to maintain or justify. As a reminder, if a company has earnings of two and a market cap of 10, its PE is five.
And if that PE drops to eight, it suffers a 20 per cent fall in value, unless earnings increase to compensate.
So, if the US PE reverts to a lower level, even if higher than historic average levels, what would corporate earnings need to do to maintain the current market value of the US equity index? In the table we show the results.
PE Level | Potential future PE | Five-year earnings needed p.a. |
Current PE | 31 | 0% |
Optimistic PE | 24 | 5% |
Average PE | 18 | 11% |
Source: Fundhouse and Refinitiv, September 30 2020
Within the table, you can see that the long-term average PE ratio of the US is 18. It may interest you that the average ratio for the UK, Europe and emerging markets is 14 in all three instances.
Since December 2007 (pre-global financial crisis), UK equities have not grown earnings in real terms, yet the US has grown earnings at around 2 per cent to 3 per cent real (a year). The average US PE is around 30 per cent above most other regions, to reflect their better earnings power.
If we assume the US reverts to its historic PE average (18), earnings will need to grow at 11 per cent a year for five years for the market to have a zero return.
If we are more optimistic about the US market and suggest it deserves a long-term PE of 24 (33 per cent higher than its average and 70 per cent higher than most other developed markets), then it needs to grow earnings at 5 per cent a year in nominal terms over the next five years to stand still.
That 5 per cent is reasonable and aligned with the 10-year number, but remember that is the earnings growth needed to deliver a zero return at a 24 PE.
And US earnings remain fairly high, in spite of the recent fall. From our estimates, they appear to be, in aggregate, around where they were in 2018.
Based on valuations, fundamentals and history, there is an argument for a doubling up of optimism to warrant investing in the US equity index at these levels. First is the view it warrants a very high PE, long term, well above historic averages.
And second, if PEs drop, earnings need to grow well above long-term averages to simply maintain a zero return.
Unless, of course, the ratio stays well above 30 over the long term, then earnings growth can be in line with history and investors will do fairly well. History suggests the odds of that are low.
Rory Maguire is managing director of Fundhouse
