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Navigating structural valuations

Simon Doyle  |  18 Jul 2017Text size  Decrease  Increase  |  
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The structural valuation backdrop for both bonds and equities remains problematic, according to Schroders head of fixed income and multi-asset Simon Doyle.


June was a challenging month as most assets found gains hard to come by. While equity markets eked out very modest gains, there was considerable diversity within the market, with emerging markets outpacing developed markets.

In Australia, healthcare was the standout sector, rising over 6 per cent in the month, whereas REITs and energy fell 4.8 per cent and 6.9 per cent, respectively. The former was driven in part by concerns about higher yields, the latter due to weak oil prices.

Bond yields rose towards the end of June as the Fed lifted rates and central banks generally proffered hawkish rhetoric, particularly around the moderation in central bank balance sheets.

There was also action in currency markets with sterling rattled by the poor showing of the Theresa May and the Conservatives in the UK election. The Australian dollar moved higher.

While the strategy benefitted from the collapse in A-REITs relative to the broader market, the offset was the positive (albeit very modest) duration position against rising in bond yields. Similarly, the fall in the pound post the election and the rise in the Australian dollar also detracted. Benign trends in equities and credit contributed little to returns.

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This time last year we reviewed the return objective for the Schroder Real Return CPI+5 per cent strategy and concluded that it remained an achievable return objective--albeit one that we would need to "be active and aggressive in managing asset allocation ... and utilise active management at a strategy level to ensure maximum incremental return through alpha generation".

At the time, many were arguing that decent real returns would be difficult to achieve against the consensus low-return world backdrop, and suggesting that there might be a case to lower the return target.

We resisted. In the ensuing 12 months, risk assets have generally exceeded our relatively moderate expectations, meaning that our targets have been met and/or exceeded without the need or opportunity for significant variability in asset allocation or the necessity to take undue risk.

A word of caution though--our forecasts are framed on a three-year horizon and are not intended to imply returns will be delivered in a linear fashion. Stronger-than-expected returns in year one simply implies returns have been pulled forward. The challenge from where we stand today remains acute.

In a cyclical context, the global economy is in reasonable shape. The major economic blocks (US, Europe, Japan, China, and Asia) are expanding, and while growth risks remain visible, recession on a one to two-year window seems a low probability outcome (barring of course a shock).

None of this, though, changes the structural challenge faced by the global economy, which effectively guarantees low growth (in both nominal and real terms) over the longer term. These factors have been well documented but as a refresher include:

• Historically high leverage limiting the potential for credit expansion to fuel sustained growth;

• Structurally low rates and ballooning central bank balance sheets (which together with high public sector leverage limit the ability of policy makers to reflate in the face of a growth/deflationary shock);

• The demographic constraints of ageing populations in key parts of the global economy (China, Europe, and Japan especially);

• Moderate trend growth in productivity (barring a technologically induced productivity shock);

• Specific debt and overcapacity problems in China (the world's most recent structural growth engine);

• Rising income/wealth inequality and the rise of the political economy;

• In Australia's case specifically, pressures on national income brought about by the unwinding of the terms of trade boom.

The structural valuation backdrop for both bonds and equities remains problematic.

In the case of equities, structural valuations have deteriorated over the last 12 months as equity prices have risen without a commensurate improvement in earnings prospects. This is evident across a range of structural valuation metrics.

While, importantly, the situation is more acute for US equities than other major markets, the structural valuation risk from all major markets is to the downside.

While bond yields are higher than they were a year ago, the rise in bond yields over the last year though needs to be put into context. Around 21 per cent of the global bond market is still trading on negative yields, while in Japan and Europe 52 per cent and 46 per cent, respectively, were issued with negative yields.

The bottom-line is that the rise in yields is modest in an historical context, meaning no material change in the prospects for bonds over the medium term--low returns seem assured.

So where does this leave us? Firstly, the task has not gotten any easier. Narrower credit spreads and more demanding equity valuations mean we are starting behind the eight ball. Beta derived from mainstream assets is unlikely to provide us with the boost we've enjoyed in recent years.

However, markets rarely move in straight lines and current narrow risk premiums are unlikely to be permanent, particularly if central banks start the long path back to policy normalisation (whatever that is). Managing this adjustment will be an important contributor to returns over the medium term.

The two critical objectives are to avoid as much of the repricing as possible and to re-enter markets when risk premiums have rebuilt and prospective returns rebuild.

Secondly, broad market beta is not our only tool. At the sub-asset class level there is considerable opportunity to both add incremental return and manage risk. We expect the realignment of currencies and interest rates to be an important source of return.

For example, opportunities in the pound and the Australian dollar as well as in European and US yield curves are being exploited for this purpose. In fact, we currently see the management of these types of strategies to be almost as important in achieving our objectives (particularly in the short run) as our broad market beta exposure.

In short, the environment is unlikely to do us any favours. We expect that the above in combination will be what gets us to where we need to be, but we also need to bear in mind we are very mindful of risk--particularly the minimisation of downside risk.

One implication of narrow risk premium is that there is little room for error and downside risk is elevated. Avoiding this will be just as important as capturing return on the upside.

The bottom-line is that we need to be realistic. Achieving CPI+5 per cent from here even over a three-year timeframe will be tough, but as we have seen over the last 12 months, it remains an appropriate objective, so too do our risk targets.

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Simon Doyle is head of fixed income and multi-asset at Schroders. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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