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Having been fearful about macro risks throughout the current market cycle, global investors’ concerns have shifted squarely to valuations.
We hear a continuing refrain about excessive valuations of the US equity market – as if other equity markets would be immune from a serious sell-off in US equities – and talk of bond bubbles.
Interestingly, history suggests that valuation is rarely the primary cause of equity bear markets. In fact, only one since the 1920s – the crash of 1987 – can be so ascribed.
Shocks and recessions come in as the primary triggers 25% and 50% of the time respectively, whereas tighter credit conditions, at more than two-thirds, are the real bull market killers.
So are valuations a problem at the moment? In an equity context it depends to some extent on the bias of the “eye of the beholder”.
Valuations are clearly elevated, but are they worryingly so? Longer-term measures, which include the inflationary 1970s, would have us believe so, but others, which take greater account of persistently low inflation and interest rates, suggest more moderate overvaluation.
What is undeniable is that this has been an unusual and unusually extended cycle.
Most of it has been driven by declining interest rates but since the correction of 2015/16, earnings dynamics and momentum have led the charge, which is much more typical of late-cycle market environments.
Fundamental factors have improved significantly and the growth environment is ostensibly supportive.
Global growth is synchronised and self-reinforcing, which in turn has boosted top-line revenue growth to levels that have generally been absent in this cycle, which has been more about cost reduction.
Earnings growth has been and is likely to remain, for now, robust and broad-based.
The US Federal Reserve has announced that it will start to shrink its balance sheet and other key players such as the European Central Bank (ECB) are initiating tapering.
However, these developments, coupled with an economic recovery, don’t yet seem to have constrained liquidity.
High-yield credit spreads, normally the best candidate for the proverbial canary in the coal mine, have continued to narrow and the dollar has weakened.
Money supply growth is broadly supportive and inflation is notable in its absence, much to the surprise of the central bankers whose attempts to increase its level have largely been frustrated.
So what should investors do at this point in the market cycle?
First, it doesn’t seem to be a good environment, in our view, to start to get carried away and chase returns aggressively.
We believe it is probably wise to be progressively counterbalancing exposure to growth assets with selective defensive positions.
In our view it is still right to keep “skin in the game”. The best periods for returns in growth assets are at the beginning of a new cycle or towards the end of an old one.
In our view, investors could consider the following actions:
- Improve portfolio liquidity. Now is not the time to be sacrificing liquidity.
- Take advantage of broad opportunity sets to generate returns that don’t depend so much on the directional behaviour of the primary asset class.
- Resist the siren song of cheap, broad-based passive exposure and be increasingly selective in terms of the exposures within asset classes that are likely to show more resilience if times get tougher.
Positioning of the Investec Global Strategic Managed Fund
Bearing the above in mind, we do believe that some caution is warranted, especially as the current ageing bull market cycle grows ever longer.
As a result, while we remain optimistic for the prospects for growth assets, given ongoing fundamental improvement, the positioning of our flagship global multi-asset fund, the Investec Global Strategic Managed Fund, is somewhat more cautious than it was a year ago, as we build in defensive positions.
A long position in US 30-year Treasuries is an example of a recently introduced defensive position.
A yield of approximately 3.2% at the time of the trade was attractive relative to our neutral rate forecast of 2% to 2.5%. We consider that this position will likely provide a positive return in the event of an equity market decline.
We have also progressively raised the liquidity of the assets in the fund by having no small-cap exposure and selling out of high-yield credit exposure.
We do still, however, see opportunities for return such as our exposure to Japanese equities.
We consider that Japanese companies are cheap relative to their global peers, that the end of a long deleveraging cycle is resulting in much better Japanese economic performance, and that they have been under-owned by overseas investors.
Our exposure has been specifically focused on companies with strong or improving corporate governance, which are either committed to improving total shareholder returns through higher dividends and buybacks or have a strong restructuring story.
Philip Saunders is head of multi-asset growth at Investec Asset Management.
This article is part of the December 2017 FundFocus survey, which appeared in the 30 November edition of finweek. Buy and download the magazine here.
