A correction doesn’t mean markets are cheap

The ancient Romans used haruspicy, a method of predicting the future using animal entrails. Thankfully our multi asset team uses something more accurate to guide our secular investment outlook. Our Capital Markets Assumption (CMA) process forecasts returns over a ten-year horizon, updated twice a year.

So, what have our latest assumptions told us? First, markets remain expensive. They have fallen quite sharply in June, but remain overvalued compared to history, which highlights a real challenge for asset owners. The construct of a 60/40 portfolio – 60% equity allocation for growth, 40% fixed income for diversification and income– has long been a staple of the asset management industry because it has delivered strong risk-adjusted returns through long equity and bond bull markets. Yet by late 2021 potential 10-year returns had dwindled to about 1.7% p.a. given the high valuations from booming post-Covid market conditions. Now, potential returns have improved to above 3% in US dollars – but this is still modest, especially if bonds and equities become heavily correlated in the face of volatility.

In such a low-return environment, when the major asset classes have both generated negative returns over six months, there is a need for considerable value-add from asset allocation and security selection decisions as well as from identifying investments that will benefit from structural growth tailwinds. “Time in the market, not timing the market” was an adage for a period of stability; it works less well during periods of change.

A word on how our CMAs work: we divide returns into three components: - Income, with yield historically the single most important factor for income-generating assets; Growth, or the extent that income is expected to grow over time; Revaluation, or the price per unit of income expected to apply at the end of the decade.

Looking within the asset classes themselves, equities remain mildly overvalued, with only Japan looking cheap, although the UK and EM are only modestly expensive. At current levels, the US (now 60% of global market capitalisation) has tailed off this year but remains expensive. Where we see compelling value is in emerging markets, particularly China. With its equity market under severe pressure amid a raft of regulatory uncertainty and intermittent outbreaks of Covid, return expectations for China and EM have increased.

Fixed income is slightly more robust relative to history – certainly from an income and valuation perspective – given the substantial increases in yields following actual and expected increases in policy rates from central banks. Credit spreads have also widened, which should provide an additional source of return across US Investment Grade, US High Yield credit and emerging market sovereigns.

Nevertheless, while the sell-off has brought us closer to fair value in both equities and bonds, markets have a well-honed tendency to overshoot both on the upside and the downside.

Only time will tell how this plays out.