Aggressive monetary policy has inflated asset prices in recent years, leading towards a position where few asset classes are attractively valued.
The expansion of multiples in equities and spread compression in bonds demonstrates this, and forces investors to reassess their core views and portfolio strategy.
Building a strategy upon valuation alone arguably lacks substance, given it is rarely a material driver of short- or medium-term market returns. It is often an anchor used to support a fundamentally biased view, or a factor to fall back on during confusion.
We take valuation into account across portfolios, but focus on developing a deep understanding of the expected fundamental backdrop we are moving into, together with the shorter-term factors.
Valuation needs to be looked at with the context of a more sophisticated assessment of market trends and the investment opportunity. This approach supports more considered and rational decision making during times of volatility, rather than knee-jerk reactions based upon fear.
January provided an example of this when fears over contagion from emerging markets were building. Prior to 2014, our stance was to maintain broad asset class positioning of a moderate overweight to equity, significant exposure to absolute return strategies and reduced exposure to fixed income assets. In the second half of last year we raised the active positions within asset classes by moving to a material preference for developed versus developing equities within our equity exposure.
Our core view is for continued equity outperformance over the medium term, due to the combination of improved macroeconomic momentum in the developed world, subdued inflationary pressures, a robust corporate sector and a lack of yield in competing asset classes.
Within equity markets, we have maintained an underweight on emerging markets given the trends coming both from the west – tapering of US monetary policy – and the east – knock-on effects of the restructuring of the Chinese economic model. These factors are likely to be here for the foreseeable future.
Regardless of the volatility in January, the framework of the core view enabled us to be calm and maintain the strategy, rather than reactionary investing driven by market turbulence.
In spite of this, we are very aware of the need in turbulent market environments to have a flexible strategy to manage portfolio risk. We are moving to an environment where volatility is likely to rise and there is a risk that corrections could be larger than we have been used to during the past couple of years.
A longer-term reduction in risk positions across portfolios would be driven by a change in the core view, with one potential catalyst being the risk of deflation escalating. This would be highly damaging to the indebted nations of the western world, where leverage is high.
Economic indicators are not pointing towards this and given that debt is now in policymakers’ hands, this means policy is likely to remain supportive. These factors point to a need to keep valuation in perspective and highlight the importance of having a sophisticated strategy.
