May 04, 2023

Valuation matters: US high yield and US equities



Like other predictive measures such as economic outlooks, inflation expectations and central bank policies, starting valuation plays an important role in forecasting investment returns. In this research, we look at the US high yield credits (US HY) and US equities to find out how starting valuations have historically predicted future returns, where current valuations are, and what they could imply for future returns.

Our key findings include:

  • Valuations have a strong predictive relationship with future returns of risky assets like equities and high yields. We analyse this relationship for both US equity and US high yield credit, at the index level.
  • US equities and US high yield credits are both classified as risky assets and highly correlated to each other. So, it is not surprising that the negative correlation between starting (high) valuations and future (low) total returns holds true for both asset classes. Using the monthly returns of the FTSE US High-Yield Market and Russell 1000 indices over the last five years, we find their correlation to be as high as 84% (end-February 2023), which is also around the long-term average. It rises to 92% in the last year.
  • There is an economically significant negative correlation between US equity valuations and future total returns. High US equity market valuations, notably the forward price-earnings ratios, are strongly associated with lower future long-run total returns. 
  • We see a similar negative correlation between starting valuations and future total returns in US HY. Tight US HY credit spreads (implying high bond prices, as spreads and yields have an inverse relationship to bond prices) are strongly associated with lower future bond returns.
  • Statistical results indicate that the predictive power of starting valuation is higher in equities for longer periods (i.e.,10yr) and for shorter periods (i.e., 3yr) in US HY credits. This result is in line with the economic intuition that the predictive power aligns most closely with the duration of risky assets.
  • Current US HY spreads, being at the 36th percentile (much lower than average and indicating higher-than-average bond prices), would suggest lower-than-average expected future bond returns. Similarly in the US equity market, a current forward P/E’s being higher than its long run average would indicate a high probability of lower future equity returns. 
  • The negative relationship between starting valuations and future equity returns tends to hold not just in the US, but in most equity markets.