The global macroeconomic backdrop is unequivocally positive. Major economies are enjoying a rare period of sustained synchronised growth (last seen in 2010 and before that in 2006) as central banks globally keep interest rates low. In fact, real rates in most G7 countries remain negative. Central banks such as the European Central Bank and the Bank of Japan continue to run quantitative easing programmes, while the US recently cut its corporate tax rates.
In combination, this saw 2017 register the strongest rate of earnings growth since 2010. Marking the ninth year of the global bull market, the MSCI Word Index was up over 23% and delivered positive returns in all four quarters for the first time since 1996 (and for seven quarters in a row). Similarly, the S&P 500 Index delivered 12 positive months for the first time in its history – and registered a record run of 14 consecutive monthly gains.
While most global investors are bullish, we are cautious
Based on sentiment and asset allocation measures, global investors are the most confident they have been in over a decade. This is most clearly reflected in aggressive asset allocation strategies, with individual investors generally reducing cash levels (to lows last seen in the Dotcom years) to buy equities. However, we have been doing the opposite in our global funds. We believe that a combination of high valuations and high complacency makes it unlikely that investors will get the results reflected in their positioning – and that a focus on capital preservation would serve them better.
Prices are high and volatility is low – a dangerous combination
If we consider cyclically adjusted price/earnings ratios, the US market has only been more expensive twice in the past century: just before the 1929 crash and during the Dotcom bubble. If we use price-to-sales ratios as a measure, the US market is higher than in the Dotcom bubble – which shows that both valuations and margins are high. In addition, average annualised volatility in 2017 (as measured by the VIX index) was the lowest on record.
The combination of strong price performance and low volatility suggests high levels of complacency. It also reflects a disconnect between pervasively bullish positioning and likely returns; a distortion we believe is amplified by passive flows (which Merrill Lynch estimates now account for 70% of daily global equity trading volumes).
We believe this is an environment in which to dial back risk, not take more on
This is backed up by our bottom-up work: not only have the gaps between the share prices of the global companies we own and our assessments of intrinsic value narrowed, but we are finding fewer new opportunities that meet our criteria. As a result, cash levels in our global funds are at all-time highs, ready to be deployed when these markets once again present attractive opportunities.
It’s not all doom and gloom: market divergences present opportunities Valuation differences within equity markets (the gaps between cheap and expensive stocks) remain extraordinarily wide. Aggressive crowding in popular stocks or sectors has pushed the prices in these parts of the markets up. This has been exacerbated by passive flows, which are increasingly dominant but not price sensitive. In contrast, out-of-favour
sectors provide the potential for mispricing. Our willingness to invest in good
companies from less crowded parts of the market – and not to invest in popular companies
that are large in the index – has served our clients well in the past, and we
believe will continue to do so.
Shaun le Roux is the Fund
Manager of the PSG Equity and PSG Flexible funds.