The bond market seems more or less unassailable in its apparent fear of deflation at the moment. Which suggests rather nasty things are about to happen to the stock market.
So here’s a contrarian take on whether equities are indeed about to turn, Japan-style — this one being expressed via the medium of P/E ratios.
In a note on Tuesday, Evolution Securities’ Philip Isherwood pointed out a difference that’s at least worth noting here (emphasis ours):
The trailing P/E for Japan at the market peak in end-1989 sat at 60x, and clearly investors were (over-)prepared to pay-up for the prospect of forward growth. On a 12-month forward consensus basis, the prospective P/E was 40x (and rose to 75x as earnings collapsed in 1990/4). Today – after the economy has been ravaged by deflation and demographics, and the equity market has been de-rated and declined by 75% – what are investors prepared to pay for Japanese 12-month forward earnings? The answer is ‘just’ 13.5x, up from a mere 10x at end October 2008.
So, as the spectre of deflation haunts European and US bond markets and economies alike, what sort of de-rating should be applied to European, UK and US equities? If one assumes that Japan’s rating might serve as a benchmark (I know there are different tax treatments etc.) that would mean that European and UK equities would have to re-rate upwards by 30% and 38% respectively, and even the ‘expensive’ US could re-rate by 5%. For, the current 12-month forward P/E multiples for Europe, the UK and the US are 10.4x, 9.8x and 12.8x respectively… The savage de-rating of these markets says that if Japan is a template, it’s already discounted!
Isherwood finishes by noting that the name of the game in equities now is deciding whether the weakening macro data — Wednesday’s edition came from some awful durable goods and home sales numbers — is evidence of true double-dip conditions, or a W-shaped recovery.
A hard game to play, that.
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And while we’re on the subject of lessons on deflation from Japan, here’s another puzzler from Stephen Lewis of Monument Securities.
Lewis reckons there’s a mismatch in the key central banking ‘lesson’ to be drawn from Japan — that if only the Bank of Japan had pushed into ultra monetary easing earlier, and with concurrent fiscal support, deflation could have been mitigated or avoided. By the time the BoJ did shift to this policy, the rot had already set in, or so the story goes.
Except deflation may have become much worse some time after the BoJ’s monetary easing. As Lewis observers (emphasis ours):
If price developments are the criterion, there was no deflation in Japan before 1999. In every year but one (1995) between 1990 and 1998, the average annual consumer price index (CPI) rose. Japan’s CPI in 1998 stood 8.8% higher than in 1990. By contrast, over the whole period from 2000 to 2009, when Japanese anti-deflation policies were supposedly more successful, the CPI fell by 1.9%. There were only two years in this phase when the CPI recorded an annual rise. They were 2006, when there was a modest 0.3% jump in the index, and 2008, when a more substantial 1.4% rise benefited from a surge in global food and oil prices…
The message for the financial markets is that the link in Japan between government bond yields and the CPI has been less close over the past twenty years than might be supposed. The sharpest part of the fall in the 10-year JGB yield occurred in the 1990s when, as we noted above, CPI inflation was still positive. BoJ figures show that a constant 10-year JGB yield of 8.36% at its peak in September 1990 had declined to 2.05% by the end of 1999. Yields could not fall much further, with the 10-year averaging 1.60% over the following decade, despite the falling CPI trend.
We’d submit that perhaps there’s another message for the market, too — that there just aren’t easy historical analogies for where the New Normal will go next, in Japan or elsewhere. Unprecedented times.
Related links:
So, is it really another lost decade for equities? – FT Alphaville
Are stock prices still too high? – FT Alphaville