A Long Way Down for US Equities?

Markets may still be overvalued after the recent correction. The sell-off in U.S. equities brought a 10% drawdown, but macro fundamentals suggest the market may still be 20% overvalued, and could go even lower if tighter supply brings higher inflation and lower growth.

The forward equity risk premium (ERP) of the MSCI Macro-Finance Model reflects the expected return premium needed to reconcile market prices with macro fundamentals.¹ Rising stock prices and higher real rates pushed the U.S. forward ERP in recent years into territory historically seen only in the late 1990’s. From this perspective, the recent drawdown reflected only a third of the total correction needed to bring valuations to their historical average.

But as Alan Greenspan saw, “irrational exuberance” can persist for years. Market corrections require a catalyst.

The supply shock of the U.S. trade war could be such a catalyst. By simultaneously creating inflation pressure and squeezing the inputs to growth, supply shocks would put the Federal Reserve in a bind — lower rates to combat recession or raise them to fight inflation and maintain credibility. The bitter medicine of a Volcker-like rate hike in the face of recession might be the least-bad option to avoid letting central-bank credibility erode and inflation expectations run loose.

The MSCI model doesn’t predict the odds of the current trade war turning into stagflation, but if it does arise, the model sees stagflation as much more damaging than demand-driven inflation. Stagflation makes central-bank policy much more difficult, and once there is a loss of such credibility, it requires much more severe cooling of real growth to rein in inflation. There are many ways for current valuations to be justified, but most of those scenarios require everything to go just right.

The author thanks Will Baker for his contribution to this quick take.