Valuations have not been looking good but, asks Wayne Nutland, fund manager-Multi-Manager Funds, Premier Miton Investors, are we about to see the flip side of the coin?
2022 has seen disappointing returns from most of the major asset classes across geographies. For UK investors, currency weakness has improved negative returns, for example, for 2022 to the end of September the MSCI World Index returned -9.3% when measured in GBP but -25.4% when measured in USD. Whilst welcome for sterling based investors, from the perspective of these investors, sterling weakness has masked the true underlying weakness in the assets.
It’s clear to see what has caused these negative returns. From relatively high, and in some cases very high, starting valuations in 2020 and 2021, asset valuations have been hit as persistently elevated inflation has caused central banks to raise interest rates further and faster than had been expected, which mechanically lowers many asset valuations and has also led to fears of recession.
Higher rates and fears of recession occurring at the same time are important. In many previous periods of equity market weakness bond yields have fallen (and prices risen) in anticipation of central banks cutting interest rates in response to economic weakness. However, in 2022, central banks are primarily concerned with fighting inflation, hence interest rates and bond yields have risen despite fears of recession.
This combination has been critical for multi-asset performance in 2022 as it has meant that bonds have delivered negative returns alongside equites, with UK gilts and GBP corporate bonds returning -26.4% and -24.5% respectively for 2022 to the end of September. Higher bond yields have also contributed to underperformance from growth focused equity funds where valuations tend to be more sensitive to movements in interest rates and bond yields compared to broad equity indices. During the same period MSCI World Growth returned -32.4% compared to -18.5% for MSCI World Value, both in USD terms.
Interest rates and bond yields had been in a downward trend for decades. Whilst it’s impossible to forecast what will be the new normal for rates, it seems likely that in contrast to many years of downward trending interest rates and yields, the risk is at least now two-way, which may argue for structurally lower weightings to bond duration and growth equities for many portfolios compared to recent years.
The flip side of the coin…higher expected returns
Asset valuations have primarily fallen due to higher interest rates, or discount rates, which tends to be positive for future expected returns. This is most clearly visible in bonds. UK gilt yields have increased significantly, with the yield on the Bloomberg UK Government bond index hitting a low of around 0.25% in 2020 increasing to about 4% at end September 2022. Yields on global investment grade corporate bond indices have seen a similar move from under 1.5% to over 5% at end September. Other assets where yield plays a prominent part, such as property, have also seen meaningful increases in yields.
As equities aren’t typically discussed in yield terms, the effect is less immediately obvious. The falls in equity markets have been caused by valuation compression as opposed to falls in company earnings which have proved reasonably resilient so far, which is another way of saying discount rates or expected returns have improved.
Equity price earnings ratios have seen meaningful declines. For MSCI World, the forward-looking price earnings ratio is in low double digits, from highs of over 20 in 2020 and 2021. Some markets are even lower with single digit ratios. The US remains more expensively valued, but even here ratios have reduced materially. Future corporate profits are of course at risk of decline, and it’s likely that analyst profit forecasts remain too optimistic and need to decline, but given the moves in multiples, a decent sized decline in equity earnings has likely been priced.
Taking the reciprocal of the price earnings ratio, the earnings yield (earnings / price), shows an increase in earnings yield similar to the yield increase of the Bloomberg Global Aggregate Bond index. Care needs to be taken in comparing bond yields (which reflect fixed coupons) and equity earnings yields (which reflect variable but typically long-term growing earnings), but in terms of change, it’s clear that both are more attractive now than previously.
As a consequence of this re-pricing, expected returns are now better across the multi-asset complex. Investors tend to be pro-cyclical in their attitude to risk, looking to add funds after strong returns and being reluctant to do so after a period of weak returns. However, whilst valuations can still fall further, a rational investor should be more positive about investing now than they were at many points over recent years.
Speculative assets such as loss making companies and crypto currencies have generally seen larger price falls, as these assets lack anchors of fundamental value like interest, profits, or in some cases sales. Consequently it’s harder to have confidence in valuations for this type of asset. Compared to recent years, many portfolios may see structurally lower allocations to such assets going forward.
Conclusion
Valuations are good indicators of longer term returns – we can’t know the valuation an investor will sell an asset at in the future, but we can estimate the valuation at the time of purchase. Valuations are not a useful guide to near term market movements; negative returns could well persist for some time given high levels of uncertainty on the path for inflation, interest rates and the economy. Furthermore, markets tend to overshoot on the upside and the downside and there’s a danger that the speed and extent of recent market moves may cause further upsets in the financial system like those seen in the UK gilt market recently. Markets may well see more downside before they recover, however for the long-term patient investor, many asset classes offer significantly improved expected returns compared to recent history.
An edited version of this article first appeared in the November 2022 issue of professional Paraplanner.
