Recap : Biggest Obstacle to higher P/E May be Fear of Higher LT Interest Rates


I’ve been writing here for some time now that the ‘fair value’ of US equity P/E ratios should be higher, simply because the rate of return for everything priced in USD has fallen sharply. The fixed income market has already priced this in – forward long term rates in USD have fallen almost 50bps from December levels. But the equity market has not. One reason may be that P/E ratios are now back at the prior cycle peaks. Nevertheless, there remains a substantial difference between returns priced in by equities and by long term fixed income products. I think one reason for this is that there is a large bifurcation between equity and fixed income investors. Most funds focus on a specific asset class, or part of an asset class. My hypothesis is that, as a percentage of total AUM, there aren’t that many funds that try to optimize between the two asset classes based on relative, risk adjusted returns. As a result, the equity risk premium remains very wide.

This is potentially important because it may explain why equity valuations haven’t richened even as interest rate valuations have. It may simply be that for most equity managers, they simply are not sure what the appropriate long term discount rate is. I think that for most fixed income specialists, the mechanisms by which the Fed and QE are now reasonably well understood, but outside that group, complains of the Fed manipulating interest rates are legion, (hint: yields are NOT that mispriced) as are comparisons of equity performance vs when QE was on or off. (While it is certainly true that the major equity corrections since Lehman have all occurred while QE was stopped, it is in my opinion a clear case of spurious correlation. The equity sell off of 2011, for example, was driven by the EU crisis, which would’ve happened with or without the Fed) What I am suggesting is that what we may need for higher equity valuations is equity investors to have a better idea of what the discount rate is. And they may only realize that current discount rates are actually fair only after the Fed has stopped QE later this year. Timing wise, this would also roughly coincide with the beginning of the 3rd Presidential Year cycle, which has historically been a period of strong equity performance. Just some food for thought.

One offs:

  • The trade balance figures for both South Africa and Turkey were bad. Yet both currencies would up essentially unchanged vs the dollar.
  • Great post on using Python for finance h/t firoozye
  • Very interesting take on HFT. h/t firoozye
  • EU Bank lending standards eased last quarter, the first time since 2007:


  • FOMC – status quo
  • BoJ kept policy unchanged as expected.
  • US ADP Employment improved to 220k vs 210k exp. The previous print was revised to 209k vs 191k prev.
  • US GDP was much weaker than expected, rising just 0.1% vs 1.2%. Housing, Business Investment, Inventories, and Net Exports were all weak. The latter two categories generated a temporary hit of -1.4%. Personal Consumption was strong, rising 3.0% vs 2.0% exp and 3.3% prev. However 1.3% of that was due to a jump in healthcare, the biggest jump in 30 years.
  • Chicago PMI improved to 63 vs 57 exp and 55.9 prev
  • EU CPI improved to 0.7% vs 0.8% exp and 0.5% prev. The Core measure rose to 1.0% as exp vs 0.7% prev
  • ECB’s Noyer said he favors additional monetary accommodation
  • UK GfK Consumer Confidence improved to -3 vs -4 exp and -5 prev
  • Canada GDP rose 0.2% as exp in Feb
  • Japan PMI declined to 49.4 vs 53.9 prev, the first sub 50 print in 14 months.
  • NZ Business Confidence declined to 64.8 vs 67.3 prev
  • Turkey Trade Balance improved to -5.2bn vs -5.8bn exp and -5.1bn prev
  • GS on the S&P rating outlook changes on EU Banks yesterday: The ultimate impact to ratings could be meaningful given that some banks still have up to 2 notches of support in their senior ratings. We do not expect a meaningful spread impact at this time though because (1) this risk should not be a surprise to investors, (2) S&P thinks at this point that regulators would have challenges resolving a systemically important bank and (3) rating changes may not be imminent given that only the outlooks were changed and ratings were not placed on review for downgrade. Recall that ratings on sub debt and Tier 1 securities do not include any notches of uplift, which is one reason we prefer owning Tier 2s/legacy Tier 1s and think further spread compression across the capital structure is warranted.
  • Markets closed tomorrow, May 1st: Germany, Hong, Kong, China, India, Mexico, Italy, France, Brazil and Chile markets are closed.
  • Enrollment in Student-Debt Forgiveness Programs Soars in 2014 – WSJ

Upcoming Data:

  • Thu: UK PMI, Yellen Speaks, Jobless Claims, PCE, ISM Mfg, Japan Employment
  • Fri: ItalyPMI, US Employment, China Non-mfg PMI,
  • Mon: AustraliaBuilding Approvals, China HSBC Mfg PMI, ISM Non-Mfg PMI, AU Trade Balance
  • Tue: RBA, EU Services PMI, NZ Unemployment, Australia Retail Sales, China HSBC Services PMI