Cebr modelling implies US equities remained over-valued by about 30% at Thursday’s close

October 14, 2018

Global equities have taken a beating in recent days, as fears of US rate rises triggered widespread sell-offs. Asian markets suffered the heaviest losses, with the Shanghai Composite Index falling 5.2% on Thursday alone, as fears surrounding the US and China’s descent into a full-blown trade war gripped markets. Meanwhile, the tech-heavy Nasdaq Index shed 4% of its value on Wednesday.

 

Despite the sharp falls, we believe that this is essentially a market correction. We at Cebr have run our longstanding stock market valuation model for the Dow and this indicates that with the 30 year US government bond yield at 3.35%, the par value for the Dow should be 17,100 to 21,600. With the Index at 25,053 at Thursday’s close, the centre of the range implies that the US equities market was then still over-valued by 29%. So further market corrections remain probable. And of course such corrections risk overshooting, particularly if they trigger margin calls and through the knock on effects in the derivatives markets.

 

Perhaps the most important result of the recent turmoil is the implications for US monetary policy. The Federal Reserve had widely been expected to raise rates when it meets on December 18th, which would be the fourth rate increase in 2018. However, if markets remain turbulent in the coming weeks, this would be unlikely. But the US faces mounting inflationary pressures, both domestic – via a booming economy and historically low unemployment – and external – through new tariffs on Chinese imports as well as elevated oil prices. However, the widespread sell-offs as well as the spike in treasury yields that have followed their most recent rate rise will have made the Fed acutely aware of the current sensitivity of markets to its actions.

 

Meanwhile, President Trump characteristically waded into the debate on Wednesday, branding the Fed as “crazy” and “loco” for its policy of raising rates, which has pushed up bond yields and thereby the cost of servicing debt. If the President were to go beyond criticism and dismiss Fed Chairman Powell because of his monetary policy, markets would take a dim view. Shades of Erdogan and his son in law…..

 

While it is our view that the period of ultra-loose monetary policy has led to asset-price bubbles, key in preventing a major global downturn will be achieving a gradual correction rather than a collapse. Although monetary tightening is necessary in the medium term, markets have sent a clear signal that a more temperate approach from policy makers would be welcomed, to provide time to adjust to a new tightening cycle. In the absence of a dramatic surge in inflation or market recovery in the coming weeks, it is difficult to envisage the Fed raising rates at either of its upcoming meetings on November 7th and December 18th, following the most recent market fallout. In light of this, we have pushed back our forecast for the next Fed rate rise from December of this year to early 2019. And obviously if the markets overshoot then all bets are off!

 

 

Author: Cebr Economist Pablo Shah, pshah@cebr.com no.: 020 7324 2843