The view that years of ultra-loose monetary policy has forced almost all financial assets to unattractive valuations is common one among investors but some market analysts point out that there are a number of areas of value remaining – especially after the recent sell-off.
Global markets have corrected over the past few months after fears over China’s economic health and a dramatic plunge in its stock market spooked investors. Our data shows the FTSE 100 is down 13.40 per cent since its peak on 27 April while the MSCI AC World has fallen 12.63 per cent over the same time.
Performance of indices since 27 April 2015
Source: FE Analytics
Markets are expected to remain volatile for some time to come. The relative calm that marked the end of last week proved to be short-lived as yesterday’s session was hit by fresh turmoil on the back of data showing a further slowing in Chinese factory output, leaving most indices nursing heavy losses.
Bearish commentators have not ruled out the risk that this volatility could lead to prolonged run of falling markets, arguing that the value of many assets is looking stretched thanks to historically low interest rates and central banks’ unprecedented quantitative easing programmes.
Capital Economics chief markets economist John Higgins said: “To some, the recent sell-off in global financial markets was merely the beginning of what will soon become a much bigger downturn, because the valuations of many assets remain excessively high.”
“However, our view is that valuations are generally not very stretched, even that of China’s stock market following its tumble. Indeed, in some cases, the valuations of assets are now unusually low. Needless to say, this does not preclude further falls in their prices, but it may cushion the downside.”
In the following article, we look Capital Economics’ arguments why emerging market equities, US equities, higher-risk bonds and commodities appear to be on especially attractive valuations at the moment.
Emerging market equities
Given the recent sell-off was sparked by worries centred on China, it’s no surprise that emerging market stocks have been hit particularly hard.
This part of the market has been out of favour with investors for some time, but the MSCI Emerging Markets index has fallen another 23.17 per cent since the start of May.
Performance of index since 1 May 2015
Source: FE Analytics
Higgins said: “Of course, some would argue that the valuations of emerging market equities as a whole are generally too high. But the price/12m trailing earnings ratio of the MSCI Emerging Markets index is now below its average of 13.0 since the start of the century.
“And the price/12m forward earnings ratio is only a percentage point or so above its average of 9.0 since early July 2005, when data are first available. What’s more, the price/12m trailing and forward earnings ratios of the MSCI Emerging Markets index are nearly six and five percentage points below their equivalents for the MSCI World index of developed market equities.”
Critics could argue that the above is due to the MSCI World itself being overvalued, but the analyst points out that the index’s the price/12m trailing is below its average since 2000 while the forward earnings ratio is only slightly ahead of its average.
Adrian Lowcock, head of investing at AXA Wealth, agrees that emerging markets look to be an area of value and says the Standard Life Investments Global Emerging Markets Equity Unconstrained fund could be a good option to play it. 
The onshore version of the fund, which is managed by Matthew Williams, resides in the IA Specialist sector but has underperformed the average emerging markets fund since inception in October 2014.
However, the unconstrained nature of the fund means that the portfolio will look very different to the index and can experience periods of underperformance as it seeks for stocks in areas of the market ignored by other investors.
US equities
If asked to name one part of the equity market that is definitely overvalued, many would opt for the US thanks to it being the prime beneficiary of the Federal Reserve’s huge quantitative easing programme.
Since markets bottomed out in early March 2009, the S&P 500 is up 158.60 per cent while the MSCI has made 113 per cent – but much of the gain here was driven by the US.
Performance of indices since Mar 2009
Source: FE Analytics
When applying the 10-year cyclically-adjusted price/reported earnings (CAPE) ratio to the S&P 500, Capital Economics concedes that it appears to be expensive. It currently stands at around 25, when its harmonic average since 1881 has been just 14.2.
“However, the CAPE ratio for the S&P 500 has been inflated by the collapse in profits that took place during the Great Recession and its average has been depressed by events that may not be repeated. These include two World Wars, an intervening Great Depression and the inflationary 1970s,” Higgins added.
“Moreover, the CAPE ratio remains far below the peak of more than 44 that it reached during the US dot com bubble, suggesting that it could conceivably climb a lot further before crashing back down to earth.”
The FE Research team has just two funds from the IA North America sector on its Select 100 list: JPM US Equity Income and Schroder US Mid Cap. Of the two, only JPM US Equity Income is benchmarked against the S&P 500.
Although the fund has lagged the S&P 500 since launch in December 2008, our analysts say its investment process of seeking to deliver growth is through dividends is an “interesting one” and says the stock-picking method used by managers Clare Hart and Jonathan Simon is “tried and tested”, albeit with a short track record on this particular fund.
Higher-risk bonds
Government bonds are another area where there is a consensus of overvaluation, as yields in most parts of the market have been compressed to historically low levels on the back of central banks’ very loose policies. The yield on 10-year US treasuries is 2.16 per cent while for 10-years gilts it’s just 1.91 per cent.
Higgins says this does not necessarily mean they are overvalued, as in many cases it is down to the “realistic expectation” that monetary policy looks set to remain very loose for the foreseeable future.
However, the economist has a degree of sympathy that government bonds’ term premiums – which measure the influence on yields of all factors other than interest rates expectations – are “unusually depressed” and act as a sign that valuations are not at their most attractive.
This is not the case for all parts of the fixed income market, though. Higgins said: “There is little evidence to support the claim that the valuation of riskier bonds is too high.”
“For example, the average spreads over treasuries over US 7-10 year BBB-rated and BB-rated corporate bonds are now around 240 basis points and nearly 400 basis points, following significant increases. This compares to averages over the past quarter of a century of 180 basis points and 335 basis points, and troughs of less than 50 basis points and not much more than 140 basis points during the ‘bubble’ years that preceded the financial crisis.”
Square Mile, the fund research consultancy, has ratings on just four members of the IA Sterling High Yield sector. Kames High Yield Bond is the highest rated at ‘AA’ thanks to its high conviction strategy, which means it is often more volatile than its peers but tends to outperform during rising markets.
The group also gives Baillie Gifford High Yield Bond, Baring High Yield Bond and Threadneedle High Yield Bond an ‘A’ rating.
Commodities
Again, given China is the world’s largest consumer of most commodities, it’s no surprise that mounting fears over its future economic health has dinted the prices of many basic materials, which makes for a strong downward trend over recent years.
Price performance of indices over 3yrs
Source: FE Analytics
Higgins said: “The valuations of many commodities – while typically more difficult to measure – now appear low after their dramatic slide. One simple way of putting their valuations into context is to compare (a log of) their prices today with the long-run trend, after adjusting for the effects of inflation. When this is done, the current valuation of industrial metals, for example, now seems quite low.”
Lowcock agrees that commodities are looking undervalued but adds that their outlook – and those of the funds that invest in mining companies – are very tied to the health of the Chinese economy, which means there is limited likelihood of an immediate rebound.
He tips Neil Gregson’s JPM Natural Resources fund for exposure to the asset class: “This fund will struggle in falling commodity prices but should deliver in a commodity bull market.”
The fund is down more than 50 per cent over three years, in line with the declines seen in commodities. However, FE Analytics shows that strong returns can be made when markets are in favour of the fund, as evidenced by its 50.16 per cent total return in 2005 and its 95.64 per cent gain in 2009.