SSGA: Current equity valuations are too optimistic

September 5, 2023

For over a decade now, developed economies (and particularly the US) have been flooded with an unprecedented amount of liquidity via quantitative easing (QE) alongside historically high levels of government debt build-up and ultra-low interest rates. In a recent paper, State Street Global Advisors examined the short-term and longer-term implications of sovereign debt accumulation, and how policy makers are likely to act in order to avoid a disorderly debt crisis.

Short-term Outlook

Over a shorter horizon, there will likely be elevated equity market volatility given a combination of high valuations, relatively slow profit growth, still tight financial conditions and reasonably priced alternative assets. The combination of sticky inflation, higher interest rates and peak public debt levels suggests that counter-cyclical fiscal intervention will no longer be as supportive as it has been in the past decade — further fueling economic and market volatility.

'We foresee more economic damage and market volatility stemming from the lagged impact of tighter monetary policies over the next year or so. The confluence of inflationary and disinflationary factors, alongside uneven lead-lag effects of monetary and fiscal policies, is now sowing the seeds of economic instability ahead,' Michael Lin, Investment Strategist in the Systematic Active Equity team, says.

From a market perspective, the current equity valuations are too optimistic and are not reflecting risks posed by the ongoing restrictive monetary policy. State Street Global Advisors considers three short-term scenarios for equity markets:

• The combination of high valuations, relatively slow profit growth, tight financial conditions and reasonably priced alternative assets (e.g., bonds) suggests that investors risk being overconfident of a recovery regime, and that a flat but volatile return for equities is likely in the short term.
• The risk of a mild recession would bring with it more equity market downside.
• In a hard landing scenario, history suggests that equity market returns could deteriorate even after policy makers begin to cut interest rates. But policy easing does not guarantee an end to market volatility.

Long-term Outlook

If history is any guide and we have passed another secular peak in federal debt, the longer-term solution to reduce existing debt will likely involve a combination of:

• A trend shift from disinflation to inflation, with policy makers accepting a higher “steady state inflation rate” and a prolonged period of fiat currency devaluation; and
• Negative or low positive real yields, given current high debt levels and large structural deficits in major advanced economies, and interest-servicing costs are becoming increasingly problematic.

'History suggests that, in the longer term, in order to reduce public debt from its generational peak, we may have to experience a prolonged period of fiat currency devaluation, and a trend shift in steady state inflation, alongside persistently lower real yields', Kishore Karunakaran, Global Head of Portfolio Strategy in the Systematic Active Equity team, says.