With so much noise politically, the advancement of financial markets has been potentially misunderstood by the investing public. The fourth quarter saw sentiment turn decisively away from emerging markets as global trade concerns took precedence. As a result, emerging market equities and debt were both sold off as market participants bought in to the Donald Trump reflation story and redirected capital towards developed market equities.
Gold and silver proved an unsafe place to hide in the last 3 months of 2016
The reflation story also saw a significant jump in bond yields and commensurate falls in fixed income prices. This was most pronounced in the U.S. where 10-year government bond yields rose sharply from 1.7% to 2.5%, and in the U.K. where gilt yields moved from 0.7% to more than 1.2%. It also triggered the reversal of approximately $5.5 trillion in negative yielding bonds, although approximately $6.5 trillion of the market remains in negative territory - mostly in German and Japanese bonds.
This also had a dramatic impact on commodity markets and the cyclical companies that are exposed to them. Gold and silver proved an unsafe place to hide, down 13% and 17% respectively in US dollar terms as the appetite for precious metals waned. However, offsetting this weakness was continued strength for oil and copper prices, jumping 9% and 13% respectively.
A combination of these bond and commodity market moves encouraged a large sector rotation among investors. Banks and financial services were obvious beneficiaries, as the higher bond yields should help banks to boost margins. Energy companies also rallied strongly following the December agreement led by OPEC to curb crude oil supply through 2017.
The central issue from our perspective is that the change in sentiment between developed markets and emerging markets is not coherently backed by changes to the long-term valuation backdrop. Specifically, we continue to witness ‘multiple expansion’ in developed markets – prices accelerating faster than underlying valuations – rather than genuine progress in fundamentals.
One of the more trustworthy techniques to assess valuations is the cyclically adjusted price/earnings ratio. This increased by a further 5% over the quarter in developed markets and is now above the concerning 20 times level, marking its highest reading since the 2008 financial crisis. The opposite is true among emerging markets, as prices have fallen relative to long-term earnings has seen the ratio fall to near decade lows under 12 times.
Long-Term Market Perspective
A central component of the obedience to a valuation discipline is to recognise that valuations can stretch significantly over time. On this basis, we direct our attention to selected contrarian opportunities that could benefit from the fundamental stretch that has taken place in markets in recent times.
At the current time, valuations among emerging markets are gaining in long-term relative appeal, although this remains segmented by country and region. We remain conscious of potential downside risks, and specifically cite attractive fundamentals in emerging Europe. Meanwhile, parts of Latin America and Asia appear less attractive overall.
Moreover, developed markets such as the U.S. have outpaced other international markets for much of the past eight years. Largely due to strong outperformance, U.S. equities appear much more expensive than international alternatives and as a result we believe it is in an end-investors best interests to place greater emphasis elsewhere.
For U.K. investors, one must also keep a close eye on the continued volatility of the pound sterling. Our current in-depth analysis points to a sterling undervaluation, although we equally appreciate that downside risk remains high. This increases the importance of the home bias and hedging as a means of maximising reward for risk in a portfolio construction context.
Lastly, fixed income markets offer a paradox of choice. So-called ‘risk-free’ government debt still appears risky in a valuation context – albeit less unattractive following the recent pickup in bond yields through the fourth quarter. Meanwhile, high yield debt is beginning to lose some of its past allure and emerging markets debt now clearly offers the most attractive valuations in the fixed income space.
To augment these insights into a practical reality, it necessitates a balance of conviction and sizing, as we seek to mitigate any downside risk in more volatile opportunities. This also involves the retention of higher cash levels as ammunition in the event of a market deterioration.
In summary, we continue to find selected opportunities whilst maintaining a general stance of conservatism.
Adhering to this process in a repeatable manner is far more important than whether the 2017 World Bank forecast is correct or not. We won’t hazard a guess as to if/when our favoured investment selections will outperform, however focusing on lower valuations infers less price risk and more appreciation potential.
