The stock market: where are we now?
The third decade beginning now is not starting with the euphorically high valuations of the first decade, nor the low prices and valuations of the second decade. Equity valuations were still extremely attractive a year ago. Although,contrary to general expectations, corporate earnings did not increase in 2019,prices – and therefore the valuation level – rose significantly.
To reduce our dependence on chronically optimistic analyst estimates, while at the same time avoiding analyses using past data only, we base our calculations on the average of corporate earnings for the previous 12 months and expected earnings for the next 12 months. This combines earnings from the recent past with expectations for the immediate future. We refer to the earnings multiplier calculated this way as the “Flossbach von Storch P/E ratio”. It was around 14 for the MSCI World at the beginning of 2019 (average of the earnings recorded in 2018 and expected for 2019). It is currently almost 18, and therefore close to the high for the past 10 years, but still considerably lower than the valuation at the start of the century.
The recent increase in the valuation level reduces the upside price potential for equities in the upcoming decade. Without a further increase in valuations, share prices would rise no faster than corporate earnings, with shareholders also receiving a dividend to increase their total return.
This analysis, however, fails to take the extremely low level of interest rates into account. Although equities have received a boost from low interest rates in previous years, it has been relatively small compared to bonds or real estate. There are two possible reasons for this. Either investors still do not quite trust the low interest-rate situation, or they do not feel that corporate earnings have much growth potential left in the medium term.
The outlook for corporate earnings depends on future economic growth, inflation and changes in (after-tax) profit margins. These parameters depend in turn on demographics, social trends, technological innovation, and the cost of climate change, as well as related government and central-bank decisions. They are naturally not easy to forecast, and even if they were, the consequences are by no means always clear – as shown by the election of Donald Trump, Brexit and the Greta Thunberg phenomenon.
A look at historical data shows that economic growth rates have tended to decline since the 1950s. This is particularly true for Western industrialised countries, as shown by the real growth rate of the US economy over the past seven decades, which decreased from more than four per cent in the 1950s and 1960s to around two per cent in the last two decades (see Figure 4). The real exchangerate-weighted growth of the global economy, on the other hand, was relatively constant over the last four decades.
No reasonable benchmark exists for the time before that, as the major emerging markets were still communist at the time. The rise of China, whose gross domestic product (GDP) has increased from around USD 1 trillion to USD 14 trillion since the start of the century, made a major contribution to the 2.9 per cent growth in global economic output over the past 10 years, a rate that is even higher than the preceding two decades.
The initial situation at the beginning of the Twenties is therefore not so bad. This can also be seen from the labour market. Unemployment is low in the industrialised countries and has even reached record lows in some countries (see Figure 5). The number of employed is at a record high – not only in the emerging markets and the USA, but also in Germany, where around 45.5 million people were employed at the end of 2019.
This trend, however, is coming to an end. Growth potential is being slowed by demographic change in many industrialised countries and China, where a generally constant population combined with an ageing of society can be expected. Meanwhile, a shortage of skilled labour is already considered a major barrier to growth by many companies and will worsen when the baby boomers retire.
Politics as a risk factor
Politics represents the biggest risk to peace and prosperity at the beginning of the Twenties. Nationalism and protectionism are spreading. The USA and China are battling for economic and technological supremacy, which makes a long-term improvement in the relationships of the two countries unlikely. The US claims to hegemony are also
adversely affecting its relationship with other countries, as shown by the sanctions against the “Nord Stream 2” natural gas pipeline and the threat of automobile tariffs against Germany.
The international free-trade system embodied by the World Trade Organization (WTO), which was established 25 years ago in Geneva, is a success story that has contributed significantly to the welfare of its members. The crisis of multilateralism, however, did not arise when Donald Trump took office. Even his opponents agree when he states that China has cleverly used its status as an emerging market to obtain trade advantages, and used its state-owned enterprises to buy companies abroad, which is forbidden for Western companies in China. The fact that a small country like Germany pays development aid to the economic giant China is also an historical paradox. Trump has cleverly used grievances like this for his political ends. A new president would do the same, however, since the fear that many Americans have of China as a new economic power is an election campaign issue that crosses party lines.
A new bipolar world order and increasing trend of global protectionism could make the Twenties a decade of deglobalisation. The growth stimulus that globalisation brought to more than just the emerging markets will lose strength and could even turn around. This would lead to lower global growth rates and higher inflation. An ongoing economic cold war would, however, not benefit either of the two world powers or their heads of state. Xi Jinping needs a prosperous China to ensure social peace. Trump needs growth and jobs to be re-elected. A disastrous trade and tariff war like the one that occurred in the 1930s should not be expected, however, if only because of the international network of supply chains and the resulting commonality of interests. A growth slowdown due to trade policy must, however, be expected.