Market views: The challenge of valuing growth assets now
Cutting interest rates has been one of the most commonly used tactics by countries to counter the economic impact of the coronavirus outbreak, along with big stimulus packages.
Given that rates were already at low levels, however, such moves spell more trouble for investment returns. Near-zero interest rates tend to mean lower yields on bonds, and this is a situation that many now expect to persist for some time.
The US, for example, has slashed its benchmark interest rates by 100 basis points to around 0% to 0.25%, and the UK has taken similar action.
Moreover, Australia and Japan have already deployed yield curve control – the central banks have set a yield target for certain maturities of sovereign bonds – and others are considering it.
As a result, as investors hunt for better returns and long-duration cash flows beyond bonds, their focus is likely to fall more heavily on assets such as listed and private equity, infrastructure and real estate.
All this poses an interesting question, says Troy Rieck, chief investment officer of Australian pension fund LGIAsuper. What do a zero cash rate and long term low bond yields mean for the valuation of such growth-oriented assets and their ability to generate cash flows into the future?
Four experts shared their takes on this topic and how asset owners should position their portfolios amid the market chaos.
The following extracts have been edited for clarity and brevity.
Simon England-Brammer, head of Asia-Pacific international advisory services and the Middle East
Nuveen
Valuations for both public and private risk assets should be supported with risk-free interest rates at or near all-time lows, for two reasons.
First, any valuation done using a discounted future cash flow method (private equity, public equity, real estate) will be worth more today if rates stay low. Second, investors are being pushed out of risk-free assets and into higher-yielding/higher risk assets by central bank purchases, which creates more demand for higher-return/higher-risk investments.
Risk premiums are unusually wide (perhaps two standard deviations) on public equities. We don’t expect this to last beyond the medium term, meaning that rates will eventually move up or the prices of risk assets will be bid up, as happened from 2010 to 2019 in global public and private markets.
Valuations on global real estate look attractive compared to global fixed income. This has been our view for several years now but has grown in conviction in 2020 with bond yields having plummeted.
We should expect valuations to be higher (i.e. offering somewhat lower forward-looking returns) on risk assets. As recently as January, valuations on global equity markets were well above the levels they reached before the global financial crisis, partly because they were being supported by much lower interest rates.
High valuations are strongly correlated with low returns over a five-to-10-year investment horizon. We expect investors will receive somewhat lower returns on growth assets due to both the deceleration in global growth and the higher valuation on assets tied to that growth (i.e. the price of growth rises as growth becomes more scarce). This is one reason why we are focused on both technology and healthcare as major themes in both our public and private investment portfolios.
Kevin Jeffrey, director of investments for Asia
Willis Towers Watson
One of the reasons for the surge in growth asset returns over the past 10 years is that investors have priced in an extension of the prevailing low-rate environment. Prior to the Covid-19 outbreak, investors had been prepared to bid up these assets, increasing valuations. When there is a re-assessment of the durability of cash flows or of risk itself, this can lead to a sharp repricing of assets.
Given the aggregate level of global debt, it is implausible to assume rates will rise substantially in the near term. Doing so would jeopardise any nascent recovery coming from the current economic crisis. Therefore, it is likely that major central banks will keep the entire yield curve at historically low levels for an extended period.
It is difficult to forecast the extent to which markets may reprice risk, and the difficulties corporates will face in being able to generate sufficient cash flows to justify valuations. We may see more downside before getting transparency on how things will develop.
Once the current volatility passes, low interest rates should be supportive of higher growth asset valuations. However, there are other forces involved – for example, expectations, market participant behaviour and the pricing of other risk premia.
Frank Benzimra, head of Asia equity strategy
Société Générale
You have two ways to look at the relationship between growth assets and bond yields. The first is that falling bond yields generally indicate lower GDP growth, hence earnings in cyclical industries could decrease. On the other hand, industries in a structural growth trend, such as internet companies, can be somewhat less sensitive to an adverse economic landscape.
The second is related to the way we value a firm. A firm is the present value of future earnings discounted by interest rates. In theory the lower the rate, the higher the valuation. That is true for all firms. But in the case of growth assets, you are making an assumption of earnings per share growing at a sustained rate for an extended period of time. The stream of future earnings is growing more quickly than the market, and compared to the broad market, these are long-duration assets.
Aberdeen Standard Investments
An environment characterised by low interest rates and low bond yields has boosted demand for real estate and infrastructure assets.
In particular, we have seen strong demand since the global financial crisis for long-income real estate – that is, real estate let on long leases to strong tenants with largely inflation-linked rents.
In terms of infrastructure, there has been demand for assets characterised by long-term stable revenues supported by inflation-linked long tenor contracts with central or municipal government counterparties.
These types of real estate and infrastructure have been seen by many institutional investors as an alternative to more traditional fixed income investing.
Demand for these kinds of private market assets is unlikely to recede as there are lots of mature pension funds in de-risking mode. This is not just a cyclical trend linked to the fallout from the 2008 global financial crisis and more recently the Covid-19 outbreak; this is a long-term, structural theme.