Stock valuations might seem fair after a long decline but investors should be cautious as inflation and earnings weakness pose more downside risk, Barclays says

• The S&P 500's valuation may look fair after the benchmark has been dragged down this year but beware of a valuation trap, says Barclays.
• Inflation is historically the primary driver of equity valuations and rates are a record highs in the US and in Europe.

Global stock valuations have dropped to pre-pandemic levels, with the S&P 500 recently dipping into a bear market. However, investors need to be careful about interpreting current so-called fair valuations as a purchase signal as there are downside risks from inflation and weak earnings, Barclays says.

The S&P 500 forward price/earnings ratio is at 17.5x compared with 19.0x at end of 2019 and a median of 17.2x from 2014 to 2019, the investment bank said in a note published Wednesday. The benchmark's forward p/e peak was 24.2x in 2020.

"It is tempting to conclude that valuations are now 'fair' and represent a buying opportunity. Such a temptation should be avoided," wrote Maneesh Deshpande, head of US equity strategy at Barclays.

The current macro backdrop is different compared with pre-pandemic conditions, he said.

"To be fair, we had also used the pre-pandemic levels as benchmarks for most of last year. But that was under the hope that we could get a complete reversal of the COVID impact, which clearly has not materialized," with China still dealing with the virus spread.

As well, he said the global economy is struggling with supply chain and inflationary pressures and central banks are racing to fend off an increasing risk of 1970s-type stagflation, especially in Europe.

Deshpande said historically, inflation has been the primary driver of equity valuations and that poses downside risk. Consumer price inflation in the US was at a near-record high of 8.3% in April and the rate in the eurozone reached 8.1% in May as energy costs soared. Energy costs stand to stay elevated with the European Union this week agreeing to cut around 90% of oil imports from Russia by the end of the year, making the move after Moscow's invasion of Ukraine in February.

"As a result of the current high levels of inflation, our fair value model points to further downside risk for valuations (~10%), especially if inflation does not subside quickly," the strategist said.

Meanwhile, earnings weakness is a further threat to equity prices even in the absence of a hard landing. "Margins are likely to decline further as the inflation tax starts to bite and the rotation from Goods to Services consumption continues to gather pace," Deshpande said. "However, continued inflation is likely to be a support for (nominal) earnings."