Market's high multiples leave no margin for error
The market remains at a high multiple. Despite September’s mild pull-back, the MSCI World Index is still trading on 18.7 times the next 12 months’ earnings — a 26% premium to the average multiple of the last 20 years.1
It is notable how resilient this multiple has been as earnings have recovered from the June 2020 trough, down only 8% over the last 15 months, while the market’s forward earnings have gained 48%.2
This has left the market at a multiple that was never seen between 2002 and 2020. There are those who justify this premium on earnings given the low risk-free rates and the absence of reasonable alternatives to equities.
But when you look at the current premium on sales it is far more stark: the MSCI World is trading on 2.2x the next 12 months’ sales — a massive 66% above the 20-year average.3
This extreme valuation versus sales is on the back of sharp improvements in profitability and brings risks for the market. Any fall in profitability will not just hit earnings, but could potentially hurt multiples as well, leading to a double-whammy effect on markets.
Company earnings have been helped by the fall in both corporate taxation levels and interest rates. The corporate tax rate has fallen dramatically in many countries and is down five percentage points or more over the last decade in France, Italy, Japan and Spain, as well as in the US and UK.4
This tailwind is very unlikely to be repeated, and may well turn into a headwind, with the UK having announced a six percentage point rise to 25% from 2023, the US discussing a rise in the headline corporate tax rate and, more broadly, multiple countries pushing for a global minimum tax rate. Interest costs must also be a risk from here, given that rates have been at their lowest levels for over 5,000 years.5
It is of course possible that investment-grade companies will continue to be able to leverage up on virtually free money and “junk” credits (high yield is clearly a misnomer) to borrow at below 3% in Europe and around 4.5% in the US,6 but any kind of interest rate normalisation will hit profitability.
Even without the profit superchargers of low taxation and interest rates, underlying profitability is high, as can be seen by looking at the EBIT margin (earnings before interest and taxes).
The predicted 12 months’ forward EBIT margin levels are over 16%, well above the 20-year average of 13%, and even above 2006’s pre-global financial crisis bubble peak of 14%.7
To be fair, there are reasons for optimism that margins could stay at these peak levels or even go higher. If there is a sustained reflationary recovery, the resulting healthy sales growth could drive further operational leverage.
In addition, earnings estimates tend to be lagging indicators (on the way up as well as the way down), meaning that there may be further earnings upgrades to come, on top of the 48% gains since June 2020.8
Against this positive view is the potential for significant cost pressures over the next decade. The current COVID-related disruptions should fade, but real structural issues could emerge:
- The experience of the pandemic has meant that corporates are keen to build robustness into their supply chains, rather than purely focusing on efficiency. The likely outcome is higher levels of inventory and short supply chains, with resulting cost increases. This shift fits with governments’ desire for on-shoring.
- The last few decades have seen the triumph of capital over labour. The emergence of emerging market workforces into the global labour pool and explicit pro-capital policies in developed markets have increased profit’s share of gross domestic product at the expense of labour’s share and boosted inequality in developed markets. There are signs that the pendulum is starting to swing back.
- Companies are likely to be expected to pay for or remedy the negative externalities that result from their activities. Carbon is the most obvious example, with momentum behind carbon markets and taxes, but it is likely to spread further. Plastic, sugar and water are physical goods where more of society’s costs will be forced on to producers. This could also apply to the societal and mental health costs that the social media giants currently shrug off.
Pricing power is key to passing these likely costs on to protect margins. Here too there is a tougher environment, given governments’ and regulators’ less friendly attitude to corporates around anti-trust and competition. At the moment there is plenty of pricing power in a world of COVID-related shortages.
This is particularly stark writing from the UK, where many would be willing to pay whatever it takes for the privilege of filling the car up with petrol.
A more global phenomenon is children urging their parents to pay whatever it takes to get their hands on a precious Xbox or PS5. They’re in such short supply, children do not even mind which console they get!
As the world moves to a steady state of normalised supply but rising input prices as the crisis recedes, we will find out who actually has pricing power. The recent experience of iron ore shows the vulnerability of commodity prices once shortages ease.
Owning high quality has not been a comfortable ride over the last year. The surprising pace of economic recovery from COVID-19, driven by massive government interventions and the vaccine miracle, has boosted the earnings of lower-quality companies, which have therefore outperformed.
Optimists see a period of strong economic growth — helped by government fiscal largesse — which will allow the earnings party to continue.
Our fear is that even if the macro environment is favourable, which is far from a given, the resulting cost pressures will make it tough for the market to hold on to the forecast peak margins in the absence of the precious pricing power which is core to our stock selection, and which has been one of the key drivers of our portfolios’ compounding over the last quarter-century.
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1. Source: FactSet
2. Source: FactSet
3. Source: FactSet
4. Source: KPMG
5: Source: Bank of England
6. Source: ICE BofA, FactSet
7. Source: FactSet
8. Source: FactSet
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Bruno is a portfolio manager for Morgan Stanley Investment Management’s London-based International Equity team. Prior to that, Bruno worked for Sanford Bernstein, where he was a Senior Analyst covering the financial sector for eight years.