By Philip Lawlor, head of Global Investment Research
Post-pandemic prospects for higher inflation (and interest rates) suggest the dramatic expansion in P/E multiples of the past few years may have run its course. While valuation levels are unreliable market-timing tools, the key question facing investors is whether a P/E mean reversion would be damaging or benign for stocks.
P/E multiples look elevated in both absolute and relative terms. They are well above their 10-year averages globally. Topping the list, the Russell 1000 now stands at a forward P/E of slightly above 23×, roughly eight points above its 10-year average of 16.1× and its global peer-group average of 15×.
Regional 12-month forward PE multiples – latest vs 10-year averages
Source: FTSE Russell / Refinitiv. Data as of February 17, 2021. Past performance is no guarantee to future results. Please see the end for important disclosures.
Considering recovery-led shifts in macro outlook, however, investors need to ask: Are these elevated valuation levels likely to persist, or will they succumb to the gravitational pull back to long-term average levels? There are two paths a P/E normalization could take.
Higher inflation could deliver a painful de-rating
As the chart below illustrates, P/E multiples have tended to run higher in periods of low or falling inflation. Such backdrops have been particularly favorable for technology and other high-growth stocks. A more rapid-than-expected pickup in inflation (and interest rates) could precipitate a broad and damaging equity-market de-rating, with formerly low-rate beneficiaries suffering disproportionately.
Changes in US CPI inflation vs US trailing P/E multiples
Source: FTSE Russell / Infinitiv. Data as of February 17, 2021. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
A 'benign’ de-rating looks possible
But not all de-ratings are bad for stocks. ‘Benign’ de-ratings occur when the outlook for EPS growth outstrips expectations and price gains – in contrast to last year’s P/E expansion, which was driven purely by price gains amid a pandemic-fueled freefall in corporate profits. As the chart below highlights, US stocks have delivered strong gains during previous periods of market-friendly P/E contractions. Given recent upgrades in forecasts for robust recoveries for the global economy and EPS growth this year and next, there seems a high probability of such a scenario playing out going forward.
Past periods of ‘benign’ de-ratings (FTSE USA)
Source: FTSE Russell / Refinitiv. Data as of February 17, 2021. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
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