Perspective - Managers' views

Capitalise on potential improvement in valuations

We believe investment market valuations are a key indicator about the level of risk in the market, and the potential for future returns.

03/05/2019

Simon Doyle

Head of Fixed Income and Multi-Asset, Australia

When I look at markets during the March month and quarter I can’t help but think about a play on a Charles Dickens’ book title: it was “A tale of two markets”. Having watched the performance of both the global bond and equity markets it is hard not to be confused, as both point to very different economic outlooks, with bond markets pricing in a relatively dire outlook, while the equity market is much more optimistic.

While we do not expect recession this year, our allegiances lie more to the bond market’s view. We expect a positive outcome from the current talks between the US and China, but there will remain lingering uncertainty around whether the deal will stick in the medium term and that US President Trump’s more aggressive approach to foreign affairs will see geopolitical risks remain elevated.

We believe investment market valuations are a key indicator about the level of risk in the market, and the potential for future returns. Making money over time involves buying cheap assets and avoiding expensive assets. By continually monitoring valuations across asset classes, we can identify which asset classes have return and risk characteristics suitable for investment, and this is the approach we take in managing our global target return strategy, which aims to generate stable returns over the medium term while minimizing volatility and the size of drawdowns.

Are markets too optimistic?

The US equity markets have gone from strength to strength, rising by 13% in price terms over the quarter to be up 8% over the past year. As equity markets generally lead earnings by around nine months this suggests a strong rise in earnings over 2019, one that is generally in line with the positive outlook based on consensus analysts’ expectations, and in line with healthy GDP growth. Yet, we struggle with US equity valuations and our return forecasts are suggesting a loss over a three-year horizon.

We have a more constructive view on Asian and Japanese equities where valuations remain the most attractive in our framework. Emerging markets are starting to look a little more interesting, but we would prefer to see more attractive valuations and/or confidence in a peak in the USD before being more aggressive on emerging market equities.

We firmly believe that equity markets have become too optimistic and therefore expect more volatility in the short run.

Meanwhile, a dovish turn by the US Federal Reserve, pausing their policy tightening, led to sharp falls in bond yields. Not only did markets move to price in the pause they went one step further and moved to price in two 0.25% cuts in the official cash rate. There was not a great deal of movement in credit spreads last month, with a small tightening in investment grade spreads, and a small widening in high yield. We still believe that credit spreads remain expensive and the market is overly complacent about growth and debt levels.

We currently favour primarily liquid and defensive asset classes like short term US Treasury securities and high quality investment grade credit.

Be positioned to capitalise on potential improvement in valuations

Market volatility and uncertainty is rising and strategies that have benefitted from central bank liquidity may struggle going forward. Investors need to be concerned about protecting capital in environments like today than taking on more risk in portfolios in an effort to hit expected return targets. Avoiding these losses ensures that portfolios are in a position to capitalise on the subsequent improvement in valuations that inevitably occur after a correction.

As volatility picks up and central banks normalise policy, opportunities to generate returns from tactical changes in portfolio positions will become more important. Active stock selection is also expected to re-emerge as an important source of return so investors should look for investment vehicles that can manage all levers of asset allocation and stock selection in order to achieve their return and risk objectives.

Overall, investors will need to be patient and moderate return expectations. The easy returns of the past few years supported by easy money from central bank policy are over and generating returns over the next few years will be a combination of protecting capital at times while also being able to reposition to tactically exploit opportunities at other times when they arise.

 

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