We live in extraordinary times. Billions of euros’ worth of bonds are being issued with no yield, yet investors continue buying them – in other words, they are paying the European Central Bank to hold their money. On its own, this backdrop is unprecedented and almost impossible to justify, but here we are. So, how does an investor make sense of it all? What should your asset allocation look like?
The only way we can explain positioning at this time is to set the background. Following the global financial crisis in 2008, interest rates sank across the developed world and stocks launched a 10-year bull-market run. Markets have cheered rising earnings, but how long will it last? Looking across history, economies and markets tend to be cyclical – trees do not grow to the sky, as the German proverb puts it.
So, we expect the next 10 years of returns to look very different to those of the last 10 years. Our view is not based on proverbs so much as market fundamentals. Looking at current prices relative to history leads us to believe most major stockmarkets are overpriced.
Valuation-driven asset allocation
To be clear, we do not advocate timing the market – history has shown investors are rarely capable of correctly calling both peaks and troughs. Instead, we advocate a valuation-driven asset allocation that acknowledges the downside risk.
Basing asset allocation decisions on valuation leads investors to direct more capital towards assets they find attractively priced and avoiding those they find dear. That should leave them positioned to take advantage of markets come what may – but with an eye towards the more probable paths.
All this asset allocation work should bear fruit for clients, especially once you factor in risk. With that in mind, here is a brief summary of our research on one of the most hotly debated topics of the hour – the US versus the UK.
Growth and US stocks have been hot lately – indeed, growth has outperformed value stocks in eight of the past 12 years. As the following chart illustrates, the US market has also outperformed ex-US in 10 of the last 12 years. Yet it is important to remember this is not always the case – and may prove a contrarian opportunity.
The world has lagged the US
Source: Morningstar Investment Management. 10-year cumulative percentage performance to 31/07/19. For illustrative purposes only
The evidence, for example, shows value outpacing growth by more than 2 percentage points each year on average since 1929. Our valuation-driven investment process leads us to consider asset classes based on how their prices compare with our estimates of fair value. In the US, then, stock prices are far in excess of what we would consider ‘normal’.
Keep in mind that an overvalued asset typically has more room to fall from its intrinsic value, which can increase its potential drawdown or loss. For long-term investors, holding undervalued assets instead of overvalued ones should lower the potential drawdown of portfolios and improves their chances for outperformance over the long haul. This even applies to the mighty US market.
Fixed income markets
Turning to fixed income, we favour the US over the UK. Fixed income markets have enjoyed one of the greatest 30 to 40-year bull markets in history. With bond yields falling from highs of over 15% in the early 1980s to lows of today, the asset class has delivered unprecedented outcomes for cautiously-minded investors. This has caused long-duration bonds to perform strongly, where UK gilts happen to have among the longest duration of any bond market.
The challenge is that the next 5, 10 or even 30 or 40 years will not be the same. Some have even likened the outlook to picking up pennies in front of a steamroller. At this juncture, it is healthy to remind ourselves of the two key roles lower-risk bonds play in a portfolio: first, as a source of return; and, second, to diversify equity risk. Here, we find a troubling mix of lower yields with higher risk for long-duration bonds, creating an unprecedented environment.
Dan Kemp is chief investment officer, EMEA at Morningstar Investment Management
Summary of convictions – UK v US
* UK equities – ‘medium conviction’: UK equities are a tale of two markets. The multinationals have scope for improving earnings, while the domestic-focused face headwinds.
* US equities – ‘low conviction’: Valuation pressures continue to be our primary concern. Profit margins remain elevated, although sector dispersion applies.
* UK gilts – ‘low conviction’: UK gilts have abnormally long duration risk, offering low reward for risk, especially if yields revert higher.
* US treasuries – ‘medium conviction’: Valuation-implied returns have reduced and barely cover inflation risks. However, the defensive attributes remain strong.
