Huw Davies, investment director in the absolute return government bond team at Old Mutual Global Investors, asks whether we are living through a time of excessively high valuations across asset classes.
Over the last 12 months I’ve heard this phrase in conversations with colleagues and investors more times than I care to mention. From equities to government bonds to credit, analysts covering all asset classes think that their own area of expertise looks unrealistically priced.
However, investing has, to a large extent, always been a relative valuation. Does an equity return of 8% per annum look attractive? Well the answer is “it depends”. If, as is currently the case in the UK, 10-year bond yields are under 1.25% and central bank rates at 0.25%, then yes, it looks pretty good. But if 8% was the expected return from equities in the early 1990s when bond yields and base rates were above 6.0%, then it doesn’t look so appealing.
So taking a closer, more defined, look at this relationship – where are UK equities on a relative basis at the moment? Market analysts use a myriad of different methods to measure relative valuations, so it’s very much a case of “you pays your money and you takes your choice”. My preferred analysis is to look at the ratio of total return between equities and bonds.
The first chart shows the ratio of the total return on the FTSE All-Share index versus the total return on the FTSE >15yr Gilt index.
This ratio certainly gave a very good buy signal for UK equities in early 2003 and early 2009, as well as highlighting the recent attractive valuation for UK equities prior to the bull run that took hold in the middle of last year.
But what about current valuations? Well, it’s difficult to make the case that equities look cheap relative to historic levels but, at the same time, it is also difficult to suggest that they are very expensive with the ratio between these asset classes below its 20-year average
In our opinion this whole argument boils down to where investors expect Gilt yields to go over the next few years. The yield on the over 15yr Gilt index is currently 1.75% and if investors expect that yield to rise back to 4-5%, where it traded between 2001 and 2010, then the current valuation of UK equities looks vulnerable.
However, that is not our expectation! Within the context of lower inflation, a lower terminal level of bond yields in the UK and across the globe (highlighted by the long-discussed secular stagnation argument1), and an ageing UK population, long-dated bond yields are likely to rise no further than 2-2.5% in our opinion, leaving UK equities, at least on this relative valuation, looking fair value.
We believe the crucial part of the valuation process is the level of the current and likely near-term risk free rate. It is key to the assessment of value in all other asset classes, too. Our core investment stance is that developed market risk free rates are on the rise but that this trend will not take rates back to pre-financial crisis levels.
For the foreseeable future the terminal level for long-dated risk free rates is likely to settle around 2.5%, in our opinion – the terminal rate denotes the fair value, long term real rate. US rates are already at these levels while other developed market rates are somewhat below, but only by 75-100 basis points. We do not believe we are returning to an era in which long-term rates are in the 4-5% bracket.
So our conclusion is that a mixture of the secular stagnation argument and the demographic problem being faced by all developed economies will keep long-term rates lower than in previous cycles. Plainly, that makes a difference for our portfolio stance when valuing long-term rates, but it also has significant implications for all other asset classes as well.