Pricey stocks overlook the world’s troubles

Last week was a bad one for the world order. Russia made new military advances in Ukraine, and the United States slapped punitive tariffs on Chinese imports. None of that spooked stock market indices, which reached record highs on both sides of the Atlantic.

Investors might question whether geopolitical turmoil has much effect on share prices. The key determinants of equity valuations are how rapidly earnings will grow and the discount rate applied to those future profits. Lower-than-expected U.S. inflation in April supports the view that the world’s largest economy is heading for a soft landing and that interest rates will start falling in the autumn.

While this short-term outlook is plausible, the world’s troubles weigh on the fundamental long-term value of equities. For a start, the mounting economic Cold War between the United States and China will dampen future growth. That will act as a drag on many companies’ bottom lines.

Meanwhile, governments in Europe, Asia and North America are ramping up defence spending as the world gets more dangerous. They need to find the extra cash at a time when they must pay for ageing populations and invest in the green transition while already drowning in debt. In coming years, taxes will rise — and companies are likely to be presented with part of the bill.

Equity valuations are not cheap even without these headwinds. Add them in and investors in stocks have more downside than upside.

WITCHES’ BREW

The West is facing a witches’ brew of geopolitical trouble. Russia’s battlefield successes in Ukraine are the main immediate danger. Rising superpower rivalry between the United States and China is a massive medium-term challenge. The world could split into two trade blocs.

These problems are intertwined. China is forming an increasingly close alliance with Russia. President Xi Jinping and President Vladimir Putin declared a “new era” in their partnership at a meeting in Beijing last week.

Meanwhile, the war in Gaza is undermining the West’s grand strategy of defeating Russia and containing China. It has distracted the United States from the war in Ukraine and fuelled Beijing’s narrative that Washington operates double standards.

Western defence spending is already rising rapidly. If Russia defeats Ukraine, there will be panicky arms-buying not just in Europe. Asian countries, such as Japan and South Korea, will worry that the United States will not be able to defend them from China any more than it could stop Moscow bludgeoning Kyiv. Though spending on arms is a boon for defence companies it is a drag on the wider economy.

Meanwhile, the war in Gaza is harming Joe Biden’s chances of being re-elected as U.S. president, according to a Reuters/Ipsos poll released last week. If his rival Donald Trump returns to the White House, the Western alliance and the global economy could further fragment — with negative consequences for economic growth.

RISING TAXES

Equities face headwinds other than geopolitical trouble. For a start, the world is going to have to pay for climate change. Countries will have to scrap dirty technology prematurely or build defences against changed weather patterns. Otherwise, they will suffer huge economic damage.

Companies will pay for some of the cost. Governments will also increase their spending, creating extra pressure on their budgets. Ageing populations will be another burden on the public purse, lifting spending on pensions and health care.

Western governments cannot keep borrowing forever to pay for all this, especially now the era of artificially low interest rates is over. Government debt as a proportion of national output in advanced economies increased to 111% last year, according to the International Monetary Fund, up from 71% just before the global financial crisis which started in 2007.

As governments increase taxation, it is hard to see companies being spared. Indeed, the hikes have already started. For example, 140 countries have agreed to a minimum tax rate of 15% for multinational companies, taking effect this year. The Organisation for Economic Co-operation and Development reckons this will raise an extra $155-$192 billion a year.

END OF AN ERA?

U.S. corporate earnings have grown exceptionally fast in recent decades. Between 1989 and 2019, they rose an average of 3.8% a year in real terms, according to U.S. Federal Reserve economist Michael Smolyansky. That is much faster than the 2.5% average at which the economy grew during the period. It is also nearly double the rate at which earnings expanded between 1962 and 1989.

Lower tax rates and lower interest rates explained all this exceptional growth, according to Smolyansky’s analysis. Operating profit, which is calculated before deducting tax and interest, rose only 2.2% a year in real terms between 1989 and 2019 — slightly less than the wider economy. Higher taxes and borrowing costs will now eat into companies’ bottom lines. What is more, rising interest rates lift the discount rate, lowering the present value of future profits. The yield on inflation-linked 10-year U.S. Treasury bonds, which averaged little over zero in the decade to the end of 2021, is now 2%.

Despite this, equity valuations are high, particularly in the United States. The ratio of price to earnings for the S&P 500 Index SPX, adjusted for the economic cycle, is 35. Apart from a moment in 2021, the only time it has been higher was during the dot-com bubble at the turn of the century.

It’s not all gloom and doom. Ukraine may be able to hold the line against Russian attacks, as the United States is now sending it new weapons after a months-long hiatus. And if Joe Biden hangs on to the U.S. presidency, geopolitical tension may calm down. What is more, the revolution in artificial intelligence is likely to boost productivity in the medium-term. Even so, given the mounting headwinds, the direction of equities is more likely to be down than up.

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