Corporate earnings and earnings growth expectations both surged in the first quarter, particularly in the U.S. However, equity prices rose even faster, pushing valuations in many markets toward historic extremes (Figure 2). Year‑over‑year earnings comparisons also are becoming more challenging as economies move further away from the depths of the pandemic recession.
Although speculative excesses have appeared in areas such as cybercurrencies, special purpose acquisition companies (SPACs), electric vehicles, and some stocks traded by retail investors, global and U.S. equity markets overall do not appear to be in bubble territory, Sharps contends.
Earnings Growth Forecasts Have Risen but Valuations Are High
(Fig. 2) Consensus estimates for EPS growth next two fiscal years vs. trailing 12 months, valuation percentiles vs. past 15 years*
*Relative valuation percentiles vs. past 15 years are based on an equal‑weighted average of next 12‑month price/earnings, price/book, and price/cash flow ratios.
Actual outcomes may differ materially from estimates.
Sources: MSCI and FTSE/Russell (see Additional Disclosures). T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.
Indexes: U.S. Large Growth: Russell 1000 Growth Index; U.S. Large Value: Russell 1000 Value Index; U.S. Small‑Cap: Russell 2000 Index; Global Equity: MSCI All Country World Index; EM Equity: MSCI Emerging Markets Index; Japan Equity: MSCI Japan Index; Europe ex UK Equity: MSCI Europe ex UK Index; UK Equity: MSCI UK Index.
That said, many broad equity averages appear stretched even after factoring in ultralow interest rates, Sharps adds. This suggests that equity investors could face more subdued return prospects going forward even if economic growth remains relatively strong.
“Valuation historically has not been a good tactical timing tool,” Sharps says. “But it’s typically been a good forward indicator of return potential relative to longer‑term averages. I don’t think the starting point today bodes very well for robust returns going forward.”
Thomson agrees that the economic recovery largely has been priced into U.S. equities. But earnings per share (EPS) for companies in many other markets have yet to rebound as quickly or strongly as they have for the S&P 500 Index. This creates the potential for non‑U.S. equities to outperform as the recovery broadens, he argues. “The reflation theme plays well in cyclicals, and [non‑U.S.] markets tend to be more cyclical.”
The reflation theme plays well in cyclicals, and [non‑U.S.] markets tend to be more cyclical.
Such a shift, Thomson notes, would break a record 12‑year‑long streak of U.S. equity outperformance relative to non‑U.S. markets. He cites several factors that he thinks potentially could reverse that trend:
- Sector rotation: Technology stocks have fueled much of the U.S. performance edge. But a slowdown in technology adoption, plus the risk of regulation and higher taxes, may neutralize that advantage.
- Higher interest rates: While the U.S. market is technology heavy, banks play a leading role in major European benchmarks. Higher rates and steepening yield curves could boost bank profitability.
- Attractive emerging market (EM) currencies: Many EM currencies appear undervalued against the U.S. dollar and other major currencies, Thomson argues. Historically, EM assets—both equity and fixed income—were most attractive when EM currencies were low, he says.
Cyclical Rebound Drives Rotation
The strength of the cyclical economic recovery also could help determine the course of an ongoing style rotation from growth to value.
The value style has outperformed the growth style strongly since late 2020, Thomson notes. Although that relative advantage could moderate in the second half, the cyclical recovery theme “still has legs,” he says. Global small‑cap stocks appear well positioned to benefit, as do many EM equity markets.
Thomson says the relative underperformance of Japanese equities in the first five months of 2021 was something of a surprise, given that earnings beat expectations at many firms—despite what he says is a tendency among Japanese corporate managers to give realistic guidance to analysts.
Earnings results for the broad Japanese averages should remain strong in the second half, Thomson predicts. Historically, he notes, cyclical recoveries have generated powerful tailwinds for many Japanese companies, because high fixed costs mean that revenue gains tend to translate directly into profits.
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Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Small-cap stocks have generally been more volatile in price than the large-cap stocks. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. All charts and tables are shown for illustrative purposes only.
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