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Are P/E ratios telling us the whole truth?

The markets are currently tough. Drilling down into the indices themselves, intraday moves vary considerably across the sectors and across the news of the day.

US
Source: Bloomberg

US markets are still digesting the hawkish tones of Janet Yellen’s Congress testimony, with the fluctuations in the banks especially sending the S&P into a very interesting range trade.

The Bank of England, the only other central bank that might actually raise rates in the ‘near future’, held nothing back overnight with its dovish outlook for the UK landscape – an almost complete reversal of previous outlooks. The highly mixed messages saw banks and asset managers moving independently of each other. Some finished in the top ten bets performers, with some in the bottom ten.

2016 is going to be a highly unusual year. Unconventional monetary policy is not only here to stay but may be also becoming the post-GFC norm? The governors are certainly suggesting the highly accommodative monetary policy is, if anything, going to become even more accommodative before it ‘normalises’.

The question that rises is what normalised monetary policy will look like over the next three to five years? The end of the commodities boom is stalling the nations of Australia, Canada and Brazil. China is busily transforming itself into a consumption nation, which is requiring a lot of attention from the People’s Bank of China, Europe is desperately trying to stay out of a recession and deflation, and Japan is yet to officially break out of its two decades of deflation.

Equity markets will continue to benefit from this global accommodation, liquidity is cheap and capital returns from investment in equities will make them a more attractive from investment over yield assets as the prospect of negative deposit yields ramp up.

This makes equity fundamentals all the more interesting. Indices price-to-earnings ratios (P/E) are sitting at or just below historical averages, suggesting there is still value about. However, the E is something I personally have been watching very closely over the past 24 months.

‘Improvement’ in earnings at quarterly or half yearly updates has consistently been down to consolidations, capex cuts and the streamlining operation. The issue with this strategy was that it always had a finite end. The leaner, meaner structures would reach a critical point between efficiency and loss of revenue, and we are beginning to see this in earnings around the world.   

Which leads to the issue for 2016 and beyond – top line growth. It is something that cannot be influenced by efficiency drives which can improve the bottom lines, it is impacted by production increases, value increases or economic increases. Production increases have seen mining companies at the expensive or value increase. Loan ‘value’ has seen increased sales at the banks, but it has created issue of margin compression. The one that has remained elusive for most is economic increases which allows both value and production to prosper.

If equities are going to see improving P/E and price-to-book ratios (P/B) in 2016 and beyond, it has to start at the top line. Consolidations are starting to hit that point of equilibrium – meaning P/Es will start to balloon as cheap cash overlooks earnings growth.

Maybe we need to look at how valuations are calculated in the new world of business. But, sales growth from the US to Europe to Asia to Australia are all in low single digit percentages. This needs to change if P/Es are going to improve.

Monetary policy has certainly supported equity markets over the past seven years, and the S&P is testament to this. However if it is to continue its drive higher in 2016, actual growth in individual firms will have to take over.

Ahead of the Australian Open  

Ahead of the open we are calling the ASX down seven points to 5183. ANZ turns ex-dividend today and after the performance of NAB yesterday, the banks may again underperform in the post-dividend market. The deal for Asciano is also heating up, Brookfield has counted Qube’s 20% stake in the company with a 15% stake of its own. The board still unanimously back the takeover offer from the Canadian firm and this just adds another layer to the deal. Certainly one to watch.

Iron ore is back below US$48 a tonne, this will bring up issues of breakeven points again in mid and junior miners. It has yet to play out in share prices too, BHP lost over 3% in London overnight, and I would expect that to translate into Australian trade today.

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