The value of valuations Real Matters

April 2015
For professional investors only
Real Matters
The value of valuations
Simon Doyle, Head of Fixed Income & Multi-Asset
One of our core investment beliefs is that valuations matter. They matter because they inform us about risk,
and they matter because over the medium term there is a strong link between valuations and future returns.
Significantly, the longer the investment horizon, the stronger the relationship between valuations and future
returns. The downside with valuations however is that they are a lousy timing tool – providing little guidance
over short-term market behaviour. However it is these shorter run factors that drive a wedge between market
prices and valuations that create the biggest opportunities in the longer run and by extension create significant
downside risks for investors.
The current market environment is case in point.
The key driver of this wedge at present are valuation agnostic central banks (US Fed, ECB & BOJ) whose
collective behaviour is motivated by their broader policy objectives and whose deep pockets are distorting
market prices across the spectrum. This distortion is manifested in the relatively obvious places like the
negative nominal bond yields (out to 7 years) in Germany and (in our view anyway) relatively full valuations in
US equities. Less obvious, and closer to home have been the re-pricing of yield based assets (like A-REIT’s)
and Sydney house prices, which have benefitted from low rates and strong investor demand (given the lack of
attractive alternatives).
While our investment process attempts to augment the implications of valuations on returns by overlaying
other factors, such as an assessment of cyclical forces and their relationship to the directional behaviour of
markets, as well as the reality of plentiful global liquidity, we believe that ultimately valuations will win out. In
our mind though, valuations act like an elastic band or a giant “bungee” cord. The further it stretches the more
severe the correction.
This later point is often neglected or glossed over by investors in the highly competitive search for both yields
and returns. Yet over the medium to long term managing the downside is incredibly important in the wealth
creation process. This brings me back to the point of valuations. Valuations tell us about future returns, but
they also tell us about risk – not so much in terms of volatility – as we do not really see this as risk, but in
terms of the risk of losing money and how much that downside risk might be. This is as important in
constructing the Real Return strategy as are future return expectations.
In the context of current market pricing we do see significant risk.
In equity markets this risk is most evident in the US – the biggest beneficiary of aggressive monetary policy
support. While our own return estimates for the US equity market suggest barely positive returns over the
medium term (say next 3 years), alternative but well-credentialed measures such as the Shiller PE indicate
similar outcomes. In fact the current Shiller PE of almost 28 times is consistent with a return over the next 10
years from US equities of less than 4% p.a. Of course a low “average” return is unlikely to be delivered in a
linear fashion and would most likely imply a period of significant market weakness before recovering this
ground. Consistent with this and the arguments laid out above, the potential for negative returns from US
equities are significant (possibly close to 1 in 3) with the potential downside rising.
My observation however would be that the current focus of market participants is more on the bond market
and the implications of potential Fed tightening on bond yields than it is on the equity market, and while this
should definitely be in scope, the real damage to investor portfolios will come from the equity side not the bond
side should markets play out in a manner consistent with the implications of our analysis.
The bottom-line for us is that now is not the time to be complacent. The impact of extraordinary policy support
has had a profound impact on asset prices and continues to do so, but its impact on the fundamental health of
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the global economy is more questionable. While the “ultra-bears” will argue that this has simply created a giant
house of cards (a view to which we have some sympathy), a more pragmatic view would simply conclude that
the risks are rising and in light of these risks we need to be cautious. Capital preservation is our starting point
and now is the time to focus on it. “Patience” has gained prominence of late with the Fed’s emphasis and while
they have removed the “patient” reference from their official text, we have not removed it from our own
In terms of the Real Return strategy, we have only made marginal changes to positioning over the March
quarter. This is mainly because not a lot has changed. That said, we did reflect our negative view on A-REIT’s
by establishing a “short” position in A-REIT futures against our more broadly positive view on the Australian
share market. Given the leverage of the A-REIT sector to declining bond yields, we also view this as an
effective reduction in duration (given the relative strength in Australian bond yields in the quarter) and have
marginally pared back our outright duration position. On the back of the impact of weak energy prices and the
consequent rise in high yield debt spreads (especially in the energy sector) we added back some high yield
debt exposure, albeit maintaining a relatively modest overall exposure given our broader view that credit
generally remains fairly fully priced.
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For professional investors only. Not suitable for retail clients.
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