Towards the end of 2024, some improvement in economic data and the result of the US elections prompted markets to once again embrace the narrative of a robust US economy, potentially reducing the need for monetary easing. This is an interesting culmination to the year marked by numerous twists and turns to the macroeconomic plot.
The year started with markets pricing in many rate cuts in the US and other regions. However, that soon gave way to concerns over stickiness of inflation and the possibility of reacceleration, leading to a drastic repricing in rate cut expectations. That was followed by rate cuts in the third quarter, which were deeper than priced in a few months earlier, after the job market showed signs of weakness.
As things stand, US exceptionalism seems to be a given but beneath the placid surface there are undercurrents that can’t be ignored. This is reflected in valuations across stocks and credit markets that seem to be stretched.
While high valuations in isolation can’t be a reason to expect a drawdown, they do imply less compensation for unforeseen risks, and the bar is low for negative surprises to shock the market.
Valuation metrics are never perfect and can often be subject to different interpretations. However, it is fair to say that the signals from different metrics today are largely consistent.
Here below, we examine some metrics that back our assessment.
US Tobin’s Q
US equity markets currently exhibit strong signs of complacency or a consensus view that that US exceptionalism will continue for the foreseeable future.
The US Tobin’s Q, a metric of US equity valuations vs. “replacement cost” of corporate assets (net of liabilities), is currently at an all-time high:
Buffet Ratio
Similarly, the “Buffet Ratio”, an indicator of US total market capitalization divided by US GDP, is also near all-time highs:
Elevated P/E ratio
More conventional Price/Earnings ratios also look elevated, especially when looking at the Cyclically Adjusted PE (CAPE):
Interestingly, even after adjusting for current risk-free rates or government bond yields, valuations look relatively frothy, although they are yet to reach the levels seen during the dotcom bubble of the late 1990s and early 2000s.
Equity Risk Premium
Below we propose a very rudimentary model (much more sophisticated and precise ones can be created) to compute the justified US Equity Risk Premium (ERP):
Credit risk premia
The situation is not that different in the credit world, where the compression of risk premia has been material. Below we compute valuation percentiles for different segments of the credit market for the last 20 years:
Credit spreads are tight
Similarly, credit market internals look quite stretched, with BBB-BB and BB-B differentials providing very limited value to investors moving down in quality. CCCs have recently exhibited meaningful tightening vs. Bs in the US, but remain relatively wide in Europe, given some idiosyncratic situations affecting large capital structures with significant weight in the CCC index.
BB-BBB Spreads
B-BB Spreads
CCC-B Spreads
Although an environment of compressed risk premia does not act as a timing indicator for a sell off, it does mean there is currently very limited excess return potential for risk assets. In other words, current market conditions encourage de-risking of portfolios and brace for potential volatility.
Value in government bonds
Therefore, asset managers have to pull all the levers at their disposal to manage risk. We have geared up for the emerging scenario by reducing spread duration, moving up in quality, cutting cyclical exposures, showing a preference for senior secured bonds, using hedging tools to play more for alpha rather than beta and focusing on refinancing/ take out trades amongst other things.
We believe that the current pricing for government bond yields basically reflects a goldilocks scenario where the support of central banks won’t be needed for the next couple of years. As we have highlighted in other recent reports, we still think that there are some pockets of weakness (namely in the job market and in the consumption space) which could trigger a need for quicker easing at some point in the next 12 to 18 months.
Given the above, we continue to see material value across government bonds in developed markets, particularly the US, Australia and the UK, as we believe they hold the best risk-adjusted returns prospects to investors. Stretched valuations lead us to adopt a more conservative stance in credit exposure compared to our historical approach.
The value of active minds: independent thinking
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