Soaring equity markets over the past year have left investors increasingly concerned about valuation drops to the assets, but experts say they are not reducing their exposure because alternatives look just as expensive, if not more.
Current equity valuations have been rising above the average valuation of the past 15 years, Tuan Huynh, chief investment officer for Asia Pacific at Deutsche Bank Wealth Management, said.
“Most markets, except for Japan, are trading above this long term average,” Huynh told AsianInvestor, “so yes, from that perspective, it looks more expensive.”
The MSCI ACWI index, which covers large and mid cap representation from 23 developed markets and 24 emerging markets, had a forward price to earnings (P/E) ratio of 16.0 as of September 30, a September J.P. Morgan Asset Management report said. The average forward P/E ratio for the index since 2004 is 13.7.
A November survey of fund managers by Bank of America Merrill Lynch found that 48% of respondents believed equities were overvalued.
“The most stretched valuations in Asia are in India,” said Bryan Goh, chief investment officer for Bordier & Cie, adding that there are more acute overvaluations in the US.
The National Stock Exchange of India’s benchmark index P/E had risen by around 18% year to date, as of November 17.
High valuations increase the risk of market bubbles and the likelihood of sharp corrections, a hazardous proposition for those with high equity allocations. But the risk of moving out of equities may be even greater, Goh said.
If you think equities are expensive, credit is even more expensive,” said the wealth manager (pictured).”[Bond] spreads are, on a historical basis, tighter than price earnings are high,” he said. “You don’t want to be getting out of equities and going into credit because you’re just substituting something that’s expensive into something that’s even more expensive."
The BofA Merrill Lynch US high yield option-adjusted spread has narrowed by around 55% since February 11, 2016, according to data from the Federal Reserve Bank of St. Louis. Meanwhile the 10 year US Treasury yield was 2.37% on November 16, versus a long term average of 6.25%, according to ycharts.com.
“There aren’t so many alternatives [to equities],” Huynh said. “From a risk premium and interest rate perspective,” he said, “equities still have a better risk return reward.
In fact, many CIOs are advising their clients to stick with equities and to stay invested, said Goh. The mantra goes, number one: equities are expensive; number two: fundamentals are good; number three: therefore you should stay invested, he noted.
The BAML survey suggests many are doing exactly that, with allocations of global equities up to 49% overweight, the highest since April 2015. And many industry professionals see room for further valuation growth, especially in Asia and emerging markets.
“Asia ex-Japan is still trading at a discount to other developed equity markets,” Eric Moffett (pictured), Asia opportunities equity strategy portfolio manager at T. Rowe Price, told AsianInvestor. “We continue to see good upside potential in the region’s equity markets going forward.”
Even for Bordier’s Goh, the current high valuations aren’t quite comparable to recent global market highs. “We were in an extreme in ’07, we were definitely in an extreme in 2000,” he said. “Now, valuations are high, things are expensive, but we’re not an extreme.”
The question for professional fund managers and institutional investors, Goh said, is: are you willing to buy in at these prices? “For the whole year they’ve missed out on the value,” he said, “because valuations have been stretched not recently but for a whole year already, and they missed this rally entirely.”
Many of these investors hid out in bonds, especially investment grade, he noted. They are now looking at their portfolios and thinking about whether or not they can justify going in on equities at this time.
Current market conditions are conducive to risk-on behaviour as well, Olivier d’Assier, head of applied research for Asia Pacific at financial risk management firm Axioma, said.
Low volatility and correlation, and high volume are all factors that are contributing to risk-on attitudes, he told AsianInvestor. “We are in active management utopia right now.”
Excess liquidity in the market is also a driver, according to Rene Buehlmann, managing director and head of UBS Asset Management for Asia Pacific, adding that the Federal Reserve's desire to reverse quantitative easing will not change that yet, unless it happens very fast.
“All our clients are looking for yield somewhere,” he said, “if you have a spike, immediately money goes to buy it, so this is probably going to continue for a little while.”
Investors who have shied away from risk have even started stepping back into the market, Adeline Tan, head of Advisory at Mercer, said. “Clients that have been underweight risk have been returning to the market,” she told AsianInvestor. “We see our clients being comfortable on their risk levels currently.”
Japan is an appealing market for Bordier’s Goh, who sees value in new technology and aging population themes there. However, the preponderance of old economy companies can make it difficult to find value.
“We like Japan from a macro perspective, but the only way you’re going to get any value of Japan is to go with an active manager or to stock pick yourselves,” he said.
Its decreasing volatility and improving economic fundamentals, as well as better than expected earnings, stand out to Axioma’s d’Assier as well. “Japan looks like a laggard for investors and getting exposure now doesn’t come with big risk costs,” he said.
However, the slow progress of economic reforms and implementation of Abenomics, as well unmet market expectations of a more aggressive QE policy by the Bank of Japan, has resulted in underperforming equity markets in Japan, said Deutsche’s Huynh.
“We have also trimmed down our allocation from an overweight to a more neutral,” he said, “until we see maybe some positive trigger to justify a higher weight in this market segment.”
Looking ahead, Asia’s improving corporate earnings and greater capital expenditure discipline, as well as improved free cash flow generation, is a positive for T. Rowe Price’s Moffett.
An expectation of gradual interest rate hikes is key for UBS’s Buehlmann. “That’s actually supportive for emerging markets in the end because it applies gradual growth,” he said, “so we will continue to be bullish on emerging markets.”
Still, clients are concerned about company valuations getting increasingly stretched in developed and Asian markets, Mercer’s Tan pointed out, as well as downside risks such as geopolitical concerns surrounding North Korea and a potential slowdown of Chinese economic growth.