Asset allocation convictions are necessary to shape and build portfolios, but investors must be aware of the behavioural biases that underpin predictions and ultimately endanger outcomes. We must therefore preface our own thoughts with an explicit statement that market predictions are an investor’s folly.
Instead of making brash comments about the short-term, we prefer to outline our best long-term thinking, which is that the investment landscape is generally expensive according to our methodology and logic.
Is the Current Market Expensive?
When considering the valuation landscape, we first think about the valuation-implied returns an investor could reasonably expect, over 10-years, and the evolution of these expectations over time. Feeding these outputs are a series of fundamental inputs, including dividends, return-on-equity, valuation multiples, profit margins and a reasonable expectation for long-term earnings growth.
When viewed holistically, a few clear insights should be observable. First, the overall opportunity set has become considerably less appealing as we enter 2018 than this time two years ago. This is typical of a bull market, where expensive valuations “lift all boats” and commensurately push down our reasoned expectations.
However, at the same time, it should be noted that our framework provides a contrarian bent, where we can see the relative attractiveness of particular regions. For instance, in recent times, the UK is looking more attractive in a relative sense, whilst the US and Pacific ex Japan look increasingly stretched.
UK Equities: Medium Conviction
UK equity valuations are becoming increasingly attractive in a relative sense, although expected returns are lower than pre-Brexit. Driving this, earnings from UK multi-nationals have been lacklustre and dividends are high. UK equities have underperformed regional peers over the course of 2017 making them relatively more attractive at this time. UK energy and financial stocks are particularly attractive, notwithstanding the increased risk to the fundamentals of the latter from ongoing Brexit negotiations.
US Equities: Low Conviction
Major US equity indices continue to hit all-time highs, boosted in recent times by the positive sentiment toward the outlook for US growth under a Trump presidency and a booming information technology sector. This has exacerbated our cautious stance, with the asset class now offering negative expected returns on our valuation analysis, such has been the sustained strength in this market.
Fundamentals too, appear to be deteriorating, with profit margins, outside of the technology and financial sectors, beginning to contract. This sees US equities offering a poor reward for risk, in our view.
The one exception to this is with regard to the US healthcare sector which has underperformed due to uncertainty over the outlook for healthcare regulation, given the Trump administration’s attempts to repeal Obamacare and reform pharmaceutical drug pricing policy. While delays in this agenda have tempered negative sentiment of late, a valuation opportunity nonetheless remains.
European Equities: Low to Medium Conviction
Investor sentiment regarding the outlook for European equities continues to improve, following a period of relative geopolitical calm, with elections in France and the United Kingdom passing without incident, and greater confidence in the economic outlook for the region.
With this, has come increasing inflows into the asset class, a typical, albeit irrational, behavioural response as investors feel more comfortable to invest. With strength in key European markets leading to a fall in future expected returns, we are becoming increasingly cautious given we have a lower margin of safety to invest, at this time.
However, opportunities for superior returns remain at a sector level. Our more positive views around European energy and financial companies have been joined more recently by a similar conviction toward European telecommunication companies, such as Telefonica, BT (BT.A), Vodafone (VOD), Orange, and Swisscom.
This follows a period of price weakness relating to concerns around revenue trends, given the challenged outlook for their established businesses and the growing importance of data, a lack of industry consolidation, threat of regulation, and investors moving into more growth-oriented sectors. Nonetheless, we believe current valuations provide a reasonable margin of safety to invest.
Japanese Equities: Medium Conviction
Valuations in Japanese equities remain reasonable in both an absolute and relative sense, and we take further comfort in the compelling fundamental developments in the asset class. In particular, we note the focus of Japanese corporates on improving corporate governance, which we expect to continue to result in better outcomes for shareholders. This is primarily through increased dividends and buybacks via improved profit margins, earnings growth, and returns on equity. With this in mind, we maintain a preference for domestic-facing companies as opposed to exporters.
Emerging Market Equities: Medium Conviction
Emerging market equities remain an attractively priced opportunity, although the extent of this has diminished somewhat, given recent price strength. Indeed, contrary to what media headlines may suggest, emerging market equities have been the strongest performing region across 2017.
Further, much of the returns in this market have come from the high-quality information technology sector, which we view favourably, meaning that future returns in emerging market equities are now more reliant on performance from other sectors.
With returns across the emerging market complex quite divergent, we continue to see company- and country-specific opportunities in the asset class, particularly with regard to South Korean and Taiwanese equities. Expected returns for Chinese equities too have fallen, and while they remain reasonable in an absolute sense, we are concerned by the risk to fundamentals posed by the increasing debt levels within the shadow Chinese banking sector.
Also of note, is our view of Russian equities, which appear attractively priced, having been depressed by weaker oil prices and poor sentiment amid international economic sanctions.
Asia Pacific Equities: Low Conviction
We retain a cautious outlook to the region, and in particular towards Australian equities. Expected returns have fallen in recent times, and as such, the asset class looks increasingly overvalued in absolute terms and relative to other opportunities. Opportunities remain, however, for those willing to move way from an index-like exposure, as concentration issues hamper the region.
Of note, we find the two largest sectors, financials and materials, to be generally unattractive. This is particularly the case in a global context, with global peers generally offering a superior reward for risk.
