Stock markets in the UK, US, Germany and France have reached all-time highs in the past year. Valuations for developed markets equities are stretched – and even emerging markets have benefitted from a stellar run over the past year.
Many multi-asset fund managers are responding to what they see as the top of the market cycle by loading up on cash. Moving money into lower risk assets.
But not Maya Bhandari and Toby Nangle of Columbia Threadneedle. They have been buying stocks over the past six months, selling bonds for equities in their multi-billion-pound portfolios.
“Economic risks are rising, we can see that. The threat of anti-globalisation, North Korea… and many measures of long-term stock value look challenging, stressed,” admits Bhandari.
“So why did we increase our exposure to equities in May? Because we think the outlook is good.”
Since the global recession, stock markets have rallied significantly. The S&P 500 index of US stocks has climbed from 683 in March 2009 to 2,561 today. Valuations understandably look stretched – the Shiller PE ratio for the S&P 500 is currently around 31x – a level last seen right before the Black Market crash of 30 years ago.
So why should investors believe that stocks could climb even higher?
“The recent rally has been caused by sentiment, quantitative easing and a low yield environment,” says Bhandari. “Not by earnings. From 2010-2015, equity markets rose but company earnings went sideways. Now we are starting to see earnings come through – earnings and share prices are once again correlated.”
Data from the MSCI All Country World Index shows that total returns in the five years from 2010 to 2015 were mostly made up of a change in forward PE – in other words, valuations drove equity returns. However, over the last two years total returns have been more balanced.
“Earnings are now driving prices,” says Bhandari. And the reality is living up to the expectation too – 2017 earnings surpassed forecasts, a trend that has not been seen in any of the past eight calendar years.
“Our own estimates for earnings are strong and support current valuations,” she adds.
The World is Challenged
Nangle and Bhandari admit that global markets are challenged; the reversal of quantitative easing, protectionism and the Chinese economic slowdown to name a few.
But with bond yields so low – and highly correlated with equity prices – the duo say the classic portfolio equation of equities, bonds and cash is broken.
“High bond yields falling have given investors super returns,” says Nangle. “But that is over. We may not be faced with rising yields immediately, super low bond yields may be here to stay, but the returns investors got from bond yields lurching lower will not be repeated.”
Nangle points to falling unemployment and good economic growth as a sign that yields will, eventually climb across the developed world. He calls the past 35 years – where bond yields have fallen and prices have risen continuously as an “historical freak of a period”.
“Our portfolio looks like we do not understand portfolio theory. We are not matching stocks with bonds. Our contention is that the environment of rising bond prices is coming to an end. Instead we expect a repeat of the period from 1945 to 1980, where you got greater returns from cash than bonds,” he says.
As a result the portfolios – five star Global Multi-Asset Income and three star Dynamic Real Return – are a blend of high volatility and low volatility assets; European equities, Mexican government bonds, foreign currency, property and Japanese stocks.
The portfolios look wildly different to their high cash, cautious, multi-asset peers at Troy Asset Management, Schroders and Miton. Time will tell which stance is the right one.
