Even as markets rebounded Monday following Friday's sell-off, investors are not out of the woods. These four major factors could continue to roil equity, fixed income and commodity markets across the world.
Markets are expensive and profit growth is stalling. The current price-to-earnings ratio of the S&P/TSX composite index is 23.2 times trailing 12-month earnings, 27 per cent above the 10-year average of 18.34 times. For the S&P 500, the benchmark's P/E ratio of 20.4 times is 21.4 per cent higher than the 10-year average.
The first chart, below, shows that the rising P/E ratios are less a matter of the "P" – price of the index rising – as it is a decline in earnings growth. The trailing 12-month earnings per share for both Canadian and U.S. stocks have deteriorated significantly since early 2015.
Global economic growth expectations are being ratcheted lower. Equities are expensive at a time when the economic backdrop is steadily weakening. The second chart shows that economists' projections for full-year 2016 growth in gross domestic product continue to head lower. Expectations for domestic growth, in part due to the temporary effects of the Alberta wildfires, have been cut in half since late 2014 and the trend is similar throughout the globe. International Monetary Fund managing director Christine Lagarde recently noted her belief that the organization's global growth forecasts will be reduced further.
There are increasing signs central banks will be less active in supporting markets. The post-crisis equity rally has been driven by central bank-driven low interest rates to a significant degree. Low rates allowed for profit-boosting corporate debt refinancing and cheaper financing for share buybacks – and also made equities more attractive relative to bonds, pushing stock prices higher.
The Federal Reserve appears set to hike interest rates, if not in September than before the end of the year, and this threatens to put the low borrowing rate trend into reverse. In addition, the Bank of Japan and European Central Bank have recently signalled less stimulus for their economies than investors anticipated.
Bond yields are rising. The yield on the U.S. 10-year Treasury bond, arguably the word's benchmark, remains low by historical measures but has been moving higher in recent weeks (from 1.36 per cent on July 8 to 1.68 per cent). Goldman Sachs believes yields will continue to climb, reaching 2 per cent by early 2017, because bond markets have been extremely expensive, central bank asset buying sprees are proving increasingly ineffective, and the market's attention has turned to fiscal, not monetary policy.
Developed world investors have been profitably piling into bond portfolios, and dividend-paying bond proxies like utilities and real estate, for many years. A continuation of the rising bond yield trend would eventually threaten returns on these popular market sectors, creating a painful set of portfolio re-allocations.
The factors above can easily give rise to morbid forecasts for investor returns in the coming year. The continuation of current economic and market trends, however, is not set in stone. Corporate profits could easily stage a comeback, for instance, that makes P/E ratios more attractive. Fiscal spending plans, like those announced by the Canadian government, could also boost economic growth.
But investors should be aware that high levels of market volatility are likely as long the markets remain expense while growth and profits decline, central banks step back, and bond yields climb.