James Athey, Investment Director, Aberdeen Standard Investments on the equity rally.
There are many, many reasons to question the sustainability of the equity rally. Firstly valuations. History suggests that if you buy equities at prevailing valuations you have a high degree of certainty that your long-term return from doing so will be low or negative in both nominal and real terms. Valuations don’t matter in the short-term but in the long-term they are all that matters. The notion that low rates alone justify higher valuations is flawed. It hasn’t mattered in either Europe or Japan for many years and instead is, I believe, merely a post-hoc justification for a market driven purely by maniacal sentiment and hopeful narratives. If rates are low because the growth outlook is weak then there is no justification for higher multiples other than as a simplistic cross asset valuation metric versus bonds. The problem is that bonds have fixed coupons and low volatility. Equities have neither rendering that simplistic comparison naïve.
Earnings themselves are reason to be cautious. Data from the Bureau of Economic Analysis shows that corporates in the US have seen profitability moving sideways since 2012 and in fact lower since 2014. Instead, what we have observed is earnings being massaged via pro forma adjustments and debt for equity swaps as companies have issued debt to buy back shares. This has been great for C-suite pay packets but at the expense of saddling companies with debt and hollowing out productive capacity.
Lastly, the economic outlook itself. The period of mechanical economic reopening has now passed but underneath this cyclical noise sits a structural problem. The economy was weak, imbalanced and fragile long before we had ever heard of COVID. Excess reliance on debt, a yawning equality gap, industry concentration and increasingly experimental and damaging monetary policy had already rendered the economy fragile and inefficient. Since March all that has happened is yet more debt has been piled on to mask the impacts of COVID. At some point the piper must be paid.