Supply of Equity and Forward Return Expectations
Adam Smith, in his book The Wealth of Nations, first introduced the concept of the invisible hand as the underlying force driving supply and demand toward equilibrium, with price as the ultimate arbiter. For example, understanding the forces of supply and demand helps explain the relationship between housing supply and rental rates in a major city or how a tightening labor market affects wage growth within an economy. Ultimately, the law of supply and demand explains the interaction between the amounts of a resource the market can offer and the quantity of that resource desired as determined by price.
But what happens if we apply this fundamental economic theory to investment markets? More specifically, can the supply of an investable asset, in this case equities, tell us anything about long-term forward return expectations? In our analysis, we explore this concept and uncover some surprising results. Ultimately, we find understanding the U.S. supply of equity relative to bonds and cash does a better job at forecasting 10-year forward returns than many of the most commonly cited valuation metrics. Today, like many long-term valuation metrics, the current supply of equity points to muted future U.S. equity performance.
How the Markets Performed
Volatility Returns to U.S. Markets as Investors Try to Balance the Future Path of Federal Reserve (Fed) Rate Hikes
U.S. stocks posted their first monthly loss since March at the hands of renewed volatility. The S&P 500® moved toward correction territory, at one point giving up all of its year-to-date gains. Remarkably, however, October 10 was the first day the index posted a daily change of more than 1% since late June. Many investors were quick to fault the downside pressure on the recent bond selloff, fresh concerns about trade tensions, and a pre-earnings season blackout on discretionary buybacks. But we believe nothing has fundamentally changed amid the market dip. The solid U.S. economic backdrop remains intact, benefits from the Tax Cuts and Jobs Act are likely still a tailwind, and the stock market is actually less overbought than it was at its January peak on a relative strength basis. Although we do not see a recession as imminent, we expect the stock market will continue to be tested in the near future.
Developed International Markets Not Immune to Downside Volatility; Italian Budget Concerns Serve as Latest Test to the European Union's Resolve
Developed international equity markets have not been immune to the pickup in downside volatility across U.S. markets over the last few weeks. The MSCI EAFE INDEX is down 9.5% for the month and down 10.8% year to date as of October 25. The market selloff has been equally distributed across developed markets. Most European exchanges have fallen to levels last seen in 2016, and more global trade-focused markets, like the German DAX, have experienced greater drawdowns. Negotiations between Italy and the European Union (EU) over the country’s budget proposal serve as the latest test to the EU’s determination to keep Italy’s populist government in check.
As Emerging Market Prices Move Lower, So Do Valuations
Chinese equities resumed their leadership, driving emerging market (EM) stocks lower in October. Chinese technology giant Tencent Holdings Ltd, the largest name in the MSCI EM Index, declined a record 11 consecutive days during the month. As a result of the drop in stock prices, the MSCI EM Index forward earnings multiple is at 11 times — the lowest valuation level for EM equities in over four years. While our long-term view on emerging markets remains positive, we believe near-term sentiment continues to weigh on stock prices.
Surface Calm Masks Underlying Volatility
The Bloomberg Commodity Index was little changed in October. However, crude oil, the index’s largest component, fell nearly 8%, with concerns over international demand and trade exacerbated by rising inventories. Additionally, industrial metal prices declined 2% despite seasonally low inventory levels. Agricultural commodities, particularly sugar and coffee, were standouts for the month, rising 25% and 18%, respectively, as a potential El Nino weather pattern threatened the supply outlook. From an economic perspective, tariffs remain a point of focus for U.S. companies. Increasing price pressures in multiple sectors were cited in the Fed’s quarterly Beige Book report. Comparatively, easing commodity inflation over the past six months may help offset end-user price increases from tariffs.