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Investor wiggle room shrinks

Investors’ options are increasingly squeezed. At the start of this year, stock markets still appeared to offer selective value: economically-sensitive stocks were still recovering from a prolonged period of underperformance and the US market appeared to be the only area where valuations were really stretched. Today, it’s difficult to make that case.

Valuations for ‘value’ equities have started to move closer to those of growth equities, while other global stock markets have started to catch-up with the US. Natural choices for recovery, such as smaller companies, have moved a long way very fast. The pool of assets that appear to leave some margin for error is fast diminishing.

Tide won’t lift all boats

Didier Saint-Georges, head of the strategic allocation committee at Carmignac, says: “There’s little question that equity market valuations are rich today […] if you look at many valuation indicators, including the cyclically-adjusted P/E multiple, we need to admit that, at least by historic standards, valuations are very stretched, particularly in some segments of the technology space.”

Saint-Georges points out that when the market has traded on a cyclically adjusted PE of more than 30x, it tends to deliver a poor return over the next 10 years. At the moment, this is only the case in the US, but other markets are edging closer.

He concludes: “Alpha generation and risk management will have to be the main drivers. The tide will not lift all boats any longer.”

Gareth Witcomb, portfolio manager in the multi asset solutions team at JP Morgan Asset Management, agrees on the need for selectivity. He believes there are a number of risks to the current optimism in equity markets: “My biggest concern is over-crowded positions. This may cap the upside in equities. Equally, if the consumer is more cautious than expected, or if there is a significant tax hike in the US, it could be disruptive. More importantly, if the virus returns in some mutated form, it would be a huge risk. After all, the number of cases is still rising.”

Already priced in

Investors are still putting their chips on cyclical recovery. The most recent Bank of America Merrill Lynch Fund Manager Survey showed a strong consensus that value stocks would outperform growth stocks. Saint-Georges says: “The consensus is not always wrong, but it’s clear that the outperformance over the past year has been very strong and highly correlated to interest rates. In other words, a lot is priced in and a pause may be warranted. This would be justified given that we are already quite advanced in the cycle.”

The performance of value stocks from here is likely to depend on the strength of economic recovery. Recent economic indicators from the US have been extremely strong, including retail sales growth of 9.8% in March, strong industrial production numbers and good growth in employment. Other developed market economies have yet to catch up, but are still showing stronger signs. It could be argued that if the recovery is strong enough, it will justify the performance of ‘value’ parts of the market.

It will also matter whether this brings inflation and this, in turn, is the major risk facing growth companies. Investors have been expecting higher inflation, given recent supply shortages and higher energy prices. However, most investors are also expecting it to pass relatively quickly – if it proves sticky it may unsettle markets.

Potentially painful collateral damage

For both value and growth, the biggest risk may be the “cessation of the never-ending support of financial markets by the central banks” said Thomas Becket, chief investment officer at Psigma in a recent blog.

He adds: “If we see a return of high economic growth and inflation, will this mean that the implicit and explicit stimulus of central bankers might have to end?

“There are also signs that bubbles are building in parts of financial markets, a situation created by rampant money creation by central banks and inefficient stimuli served up by governments. If any of these bubbles burst, the collateral damage across expensive and complacent asset markets could be painful.”

EM to the rescue?

But are there parts of the market which give investors more room for error? Certainly, emerging markets appear to offer more value than other regions, in spite of recent concerns on the vaccine programme and new variants in Brazil and India.

In its most recent note, the BlackRock Investment Institute said: “We see the economic restart and greater stability in US government bond yields supporting emerging market assets over coming months. Their valuations appear relatively attractive in a world of low yields after a choppy start to the year.”

However, it also argues that there is a large dispersion within emerging market fundamentals and that demands a selective approach.  

Witcomb argues that there is still value in Europe. A slow vaccine rollout has dented sentiment towards the region, but it is starting to improve, helping European growth to catch up. “European equities do make sense. We seem to have reached peak pessimism on Europe.”

He also points to some higher dividend stocks, which still look “incredibly cheap versus the broader market.” He has recently removed the dividend target of 4% for income stocks in the portfolio to allow the inclusion of stocks that are reinstating or growing their dividends. He adds: “I still think the reopening trade is the right one to lean into. Economies are going to emerge very strongly this year as the vaccine rollout gathers pace.”

The market environment is becoming more precarious as valuations rise. Investors may need to look deeper for parts of the market that provide them with some wiggle room should recovery not materialise as expected.

Part of the Bonhill Group.