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High valuations scare investors seeking return

Axioma’s Melissa Brown

Money management executives and investors are in a quandary. They are in need of returns and require a risk-on stance for their investments, yet they are grappling with fears over high valuations.

Highlighting concerns was the latest "Trends, Risks and Vulnerabilities" report from the European Securities and Markets Authority, in which the Paris-based supervisory body said it sees valuation risk at its highest level due to financial weakness and geopolitical uncertainty. ESMA's report cited high asset price valuations as the "major risk for European financial markets in the second half of 2017," with the main risk drivers identified as uncertainties around geopolitics, the resilience of economic growth and debt sustainability.

A number of money management executives said they agree valuations in global equity and credit markets are high. However, while some have moved to take profits from what they see as expensive valuations and are cautiously risk-on, they generally agree markets are not yet in bubble territory. Some are even anticipating further upside moves in European equities in particular.

And they are in agreement over the need to remain risk-on in order to satisfy investors' thirst for returns.

"Yes, (managers) are worried that we are in or near a bubble, and there is some source of risk that, while currently unknown, will rear its ugly head," said Melissa Brown, New York-based director of applied ​ research at Axioma Inc. "I don't know any managers who are not concerned."

But "to some extent they can't make big moves to reduce their risk because they can't afford to miss out. There is an old saying that the worst thing a manager can do is to miss out on the upside," Ms. Brown said.

That fear is not confined to money managers. In a blog post Sept. 13, George Bonne, New York-based executive director in the equity factor research team at MSCI Inc., wrote that tail risk fears "did not take time off this summer, but have continued to increase." The index provider sees "plenty of reasons for investors to continue buying downside protection" including rising geopolitical tensions.

Backing off

Some money managers have dialed risk down.

"High valuations in certain segments of the market such as U.S. equities remain a concern for us especially as risk factors connected with the Fed policy, geopolitical developments and legislative issues in Congress continue to sharpen," said Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers in London. "In addition, the excess liquidity deployed by key central banks has shown up as asset price inflation rather than consumer price inflation. With the business cycle especially in the U.S. so advanced, asset valuations which are now at historically high levels are a concern."

LOIM executives think the ability of bonds to protect against the downside in the business cycle and a subsequent hit to equities "is very limited given low levels of yields currently," and duration risk "is not fulfilling the role it historically used to in a diversified portfolio. As a result, we are focused on outright drawdown protection as we continue to position ourselves to take advantage of strengthening global growth," as well as cheaper areas such as emerging markets, Mr. Ahmed said.

"The old market saying is that a bull market climbs a wall of worry — and we have had a lot to worry about since the global financial crisis," said Neil Dwane, London-based global strategist at Allianz Global Investors. "However, many markets are now more influenced by central bank policy and (quantitative easing) — and thus we have lower for longer, we have low volatility, and we have tremendous overvaluations in many bond markets and then by implication some sectors of the equity market. I would argue, despite current hopes of a global synchronized upturn — which we do not share — that global growth will remain dull at best."

Mr. Dwane said any asset bubbles are most likely to be found in sovereign bonds and parts of the equity market in technology and biotech. "However, given the power of QE for a decade, all asset classes are now quite correlated and will move in unison if there is a setback," he said.

Cash not really an option

After a strong first six months of 2017, "many teams have taken risk off the table," he said, although holding cash doesn't add anything to the portfolio and might even detract. "So tactically, we are less risk-on but strategically would argue that if you take no risk, you will earn no return longer term, which will thus erode the purchasing power of your savings."

Money manager Robeco's latest five-year expected returns outlook came to "similar conclusions as the ones presented in ESMA's report: most markets have become more expensive, which will mean that investment returns will be lower in the years to come," said Lukas Daalder, Rotterdam, Netherlands-based chief investment officer. "The main deviation compared to ESMA is probably the tone of voice. Credit spreads are low, but to therefore qualify market and credit risk 'very high' or to speak of 'excessive risk taking' is overdoing things."

And Christian Hille, Frankfurt-based global head of multiasset at Deutsche Asset Management, said there are some signs of overheating in real estate markets thanks to low yields, and historically tight spreads in credit. However, equity valuations "are underpinned by solid earnings growth and a stable macro environment."

Mr. Hille said: "Overall, we are late in the cycle with volatility at historically low levels which might be seen as a warning signal for some market participants as well. However, analysis has proven that we can stay in such an environment for quite some time, with asset prices even accelerating before we change direction."

The expensive nature of credit markets has pushed some investors to take profits. "We did take down some risk in the summer in some of our strategies, particularly U.S. credit, where we'd reached the cycle lows," said David Riley, head of credit at BlueBay Asset Management in London. The move was not so much related to fears of a bubble or a crash, "but it just looked expensive."

But where Mr. Riley does agree with ESMA's warnings is "if that assessment in terms of growth and expectations proves wrong, and we see a significant downturn in global growth, then that's not priced in markets and that would clearly have an impact." Ms. Brown agreed that "markets seem most vulnerable to less-than-expected economic growth."

Robeco has "steadily reduced our allocation to credits and high yield as spreads declined and have generally limited our exposure to the most expensive asset out there" — government bonds, said Mr. Daalder. While executives acknowledge the U.S. stock market is too expensive, "it is equally clear that momentum is still very strong," he added.

Signs of improvement?

Other money managers are absolutely risk-on.

"There has been significant coverage recently suggesting that asset valuations, including equities, have entered irrational territory," said Rory Bateman, head of U.K. and European equities at Schroders PLC, in market commentary dated Sept. 13. He said investors could see a 30% market appreciation from current levels on a three-year view, "despite the current weakness in markets induced by Korean tensions or fears around growth sustainability."

And Bob Browne, executive vice president and chief investment officer at Northern Trust Corp. in Chicago, said the firm is overweight global equities "by 10% in total relative to our strategic benchmark," and also holds a 5% overweight position on U.S. high yield. While executives understand the "bearish view that equities seem expensive by some traditional valuation measures and that high-yield credit spreads are tight relative to history … we do not see a catalyst for fundamental deterioration."

If anything, Northern Trust executives see the positive economic backdrop and low interest rate environment as catalysts for improvement, he said.

Any correction in the markets would be a buying opportunity said John Bilton, London-based global head of multiasset strategy at J.P. Morgan Asset Management (JPM). While valuation matters over the long term, in the short term it "is not an especially strong determinant of returns. So in sum, are valuations rich? Yes, a little. Are we expressly concerned as a result? No, because although corrections can happen during equity bull markets, we see limited risk of a recession over the next 12 to 18 months and so would view any dip in markets as a potential buying opportunity," he said.