Just focus on the facts, says the M&G Multi-Asset team, and an important perception begins to dawn
It is interesting to think about how much investors have been surprised in recent years, perhaps often without realising it. For example, the performance of mainstream government bonds over the past 18 months or so has brought yields in some parts of that market to a level that, some time ago, most people would have considered not just unlikely, but impossible.
Now, the consensus seems to believe that negative real bond yields are perfectly plausible. This is because most investors’ frameworks are based on their most recent experience, which can make them quite easily forget what they used to believe.
For us in the M&G Multi Asset team, the key is to approach investment decision making with humility. That means being honest with ourselves about how much unique insight we can really have, and accepting how much there is that we cannot know or be sure about.
This allows us the mental flexibility to expect to be surprised, even if we cannot know when or how. We believe it is rarely a surprise when market forecasts turn out to be wrong. It is very difficult to get these things right on a consistent basis, because there is really very little anyone can know about the future.
Focus on Valuations, Not Forecasts
Therefore, most predictions are actually based on investors’ most recent experience of the past. In our view, investment decision making should avoid forecasting and focus instead on what valuations today are signalling about how attractive different assets may be, in the current environment.
This process can be more difficult than it sounds. The temptation to try and forecast markets may exert a powerful emotional pull on investors. It can be very uncomfortable to admit that we do not know what the future has in store. We believe the best chance we can give ourselves of navigating such uncertainty is through disciplined adherence to an investment process that focuses on the facts.
For us, a framework based on observable facts about where asset valuations are today versus where they have been in the past creates rigour and discipline. However, it should not mean trying to create a mechanistic perspective. There is danger in being too anchored. Therefore, we overlay our valuation analysis with questions about why valuations might have moved away from long-term averages. Sometimes, it is a shift in the fundamental economic facts. But more often, we feel it is a shift in sentiment – which is less likely to be permanent.
The Yield Conundrum
When we look at the value on offer across the global investment landscape today, the immediate question for us is: with real cash rates negative, why would anyone still be happy to hold cash, when it costs them money to do so? Some real bond yields, even at the long-end, are also very low nominal, or even negative real.
Yet, even today, we still see huge demand for perceived ‘safe haven’ government bonds. Even credit yields are not particularly attractive relative to historical norms. In fact, in developed markets today, only selected equities are offering attractive real yields. Even though equities have performed well over the past couple of years, valuations in many regional equity markets remain attractive with real yields still higher than historical trends and consensus forecasts suggest they should be, according to our valuation framework (see chart).
Yields, February 2015
Equities at a Discount to Risk
In our view, the global fundamental picture today points to continued gradual recovery, albeit with much regional dispersion, rather than another likely recession. Trends in terms of profits and growth are positive in most places, while global policy remains largely very accommodative and the recent collapse of the oil price could provide a very meaningful boost to growth. Therefore, our central observation in terms of strategic positioning at the moment is that equities are currently being offered at a significant discount, at a time when the global economy is actually doing just fine. We think this situation is the result of risk aversion, short-termism and a lack of willingness to wait for opportunities to pay-off over a medium-term time horizon.
The Mental Scars from 2008
We believe the reason for the ongoing distortion in risk premia shown in the chart above is attributable to behavioural factors. In our view, investors continue to struggle with the mental scarring of the 2008 financial crisis, which is causing them to demand too much compensation to hold so-called ‘risk assets’. Macro uncertainty persists and over the past 12 months or so, we have observed a notable shift in investor sentiment.
While the facts about the global economic outlook have been broadly improving, investors still seem to be struggling to accept that a well-seated recovery is indeed underway, because they are anchored by their recent experience in a fragile global outlook. This means, even while maintaining a positive economic outlook, we should except a considerable degree of volatility across financial markets over the period ahead. One thing we can be fairly certain of is that we will be surprised this year. Most likely by factors that no-one has even thought of yet. However, in our view, short-term volatility should not be confused with genuine risk (which we believe is the potential for permanent capital loss), and may actually present some compelling investment opportunities.
