With prices and earnings both at high levels, valuations – measured by the price-to-earnings (P/E) ratio) are not stretched in our view; in fact, most valuation measures are at or only slightly above historical averages.
Performance of indices over 5yrs
Source: FE Analytics
Regionally, the US may be more expensive and emerging markets cheap, but overall, the MSCI world sits at reasonable valuations, in our view.
When we take a long-term view, indices still have some catching up to do before they return to their long-term channel, providing further comfort.Regionally, we think that European stock markets will continue to benefit from their discount relative to the US and that the valuations gap will close, while emerging market multiples may need to wait till later in the year to improve in a more meaningful way.
Institutional investor surveys tell us that many investors are sitting on significant holdings of cash and we believe the same is true for private individuals. This is in spite of very low cash rates and limited prospects for interest rate hikes in the West.
The ECB may keep its rates at or near the current level for up to 4 years, while the Bank of England may be at the other side of the spectrum, but it may still take several years before benchmark interest rates get anywhere close to 3 per cent.
High cash levels and low trading volumes reflect a lack of conviction and some nervousness about valuations. While we have addressed the latter above and conveyed our optimism about the outlook for equity and credit markets, we think there are further implications.
First, high cash levels tend to be a contrarian ‘buy’ signal: as many investors are waiting for a dip to buy at better levels, we believe that these dips will be less pronounced as new money is being put to work when corrections occur.
Secondly, the low volumes and low volatility in indices and options markets also mean that investors see less downside risk, which should be supportive for valuations.
Hedge funds, however, could do with some more volatility. Stability limits their opportunity set and we have reduced our allocation to hedge funds as a result. We maintain a small overweight position, though, because we believe that they are an important diversifier in portfolios and are less likely than equity and bond markets to be hurt if bond yields were to rise unexpectedly.
Also, we continue to see opportunities for hedge funds in relative value trades in emerging markets, the capital structure of credit markets, changes in the shape of the bond curve, M&A transactions and changes in corporate dividend policies.
The year so far has been positive for both equities and bonds, which is puzzling some investors, as these assets often move in opposite directions.
We see several reasons for this. First, equity and bond performance reflect an economic environment that is neither too hot nor too cold: economic and earnings growth is strong enough to slightly exceed analysts’ expectations and satisfy stock markets, while growth and inflation are weak enough to keep bond yields from rising from their current low levels.
Performance of indices in 2014
Source: FE Analytics
The second reason is that ample global liquidity continues to fuel asset price inflation across different asset classes, but is principally benefiting equities, bonds and real estate.
There are no signs of any let-down on this front yet, as the European Central Bank (ECB) recently accelerated its liquidity injections and is thereby compensating for reduced liquidity coming from the Federal Reserve (Fed). We thus think that diversified portfolios will continue to broadly benefit from this global liquidity and asset price inflation.
We think both credit and equity markets will continue to do well and provide good complements to each other in diversified portfolios.While future returns may be less than those achieved in recent years, we think that cash positions will continue to underperform both bonds and equities and thus hold an opportunity cost.
Among the fund managers with high cash weightings at present are head of multi-manager at Schroders Marcus Brookes, Troy’s Sebastian Lyon and Investec's Alastair Mundy.
We looked at these bearish managers in more detail in a recent FE Trustnet article.
