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Why Tilney believes equities aren’t as expensive as everyone thinks

20 July 2017

Chris Godding, chief investment officer at Tilney Group, explains why equity valuations aren’t excessive across the board and where he sees the best opportunities.

By Lauren Mason,

Senior reporter, FE Trustnet

Overall equity valuations aren’t as expensive as most investors believe them to be, according to Tilney Group’s Chris Godding (pictured), who said there are still opportunities within the asset class.

This is despite widespread fears that equity valuations are stretched at the moment, with indices such as MSCI World up 87.26 per cent over the last five years.

However, the chief investment officer argued that valuations across most regions are relatively on par with their historic long-term averages, as measured by their MSCI-CAPE ratios. 

“The MSCI-CAPE is slightly different from the Shiller-CAPE; the Shiller uses reported earnings rather than operating earnings and the operating numbers are much more effective on an extended basis,” Godding explained.

“If you are a mean reversion fan – and to some extent we are – you would look at these numbers and ask where we are relative to the long-term mean.

“The mean ends up being a point you pass between one extreme and another, but the situation at the moment is that we’re fairly valued across the board.”

As shown in the below table, CAPE ratios of developed market indices are relatively in-line with their long-term averages, with the exception of the US market which is on a slightly higher valuation relative to history.

 

Source: Tilney Group

Tilney Group is indeed underweight US equities at the moment, although Godding pointed out the US economy has changed significantly over the last 20 years. For instance, he said the decline of its manufacturing industry has paved the way for capital-light, consumer-driven firms to come to the fore.

“You could argue that Facebooks and the Googles and Netflixes of this world do have very high returns on capital and therefore justify a higher valuation relative to the historic mean,” the CIO said.

“I do think the composition of the US market has changed since the days when the Rust Belt dominated the index.”


Tilney Group has a neutral stance on equities generally. However, the team believes equity markets could pause for breath during the second half of the year.

While markets may not move much though, Godding expects the composition of indices to change “materially” over the coming months.

“The earnings revisions that have been moving positively since the end of 2015 are essentially the result of analysts that are upgrading and downgrading earnings – that has sharply moved negative recently and that’s been driven by the materials sector, the energy sector and healthcare,” he explained.

“That is a little bit of a concern. You need the support for earnings to drive the markets higher and monetary policy is essentially a neutral factor.

“We need to see strong fiscal policy and we need to see global growth pick up generally, because earnings now are becoming the driver as you move away from extreme monetary policy.

“With that in mind, the reason we’re slightly more cautious is we expect less out of equity markets in the second half.”

One area of the equity market the CIO is particularly cautious on is technology, given high levels of investor euphoria and the potential for rate rises. On the other hand, he expects financials to benefit from tightening monetary policy.

“If we do see higher interest rates, that will affect these high growth ‘unicorn’ or FANG stocks because they are very vulnerable to that discount rate moving higher,” he warned.

Performance of indices over 5yrs

 

Source: FE Analytics

“The financials sector – which has struggled because yield curves have been flattening –should benefit as yield curves start to steepen. But when you get to the point where monetary policy is no longer accommodative, you become more dependent on earnings growth and fiscal policy.


“When you have 70 to 80 per cent of government offices in the US empty and you really have no functional government, we think that could lead to a global policy void. At the moment if you don’t have fiscal policy in the US, it leaves the economy vulnerable to disappointments with regards to earnings growth.”

Despite his relatively cautious outlook on markets, there are indeed areas that Godding believes to be particularly attractive.

For instance, he said emerging market equities are actually trading on significant discounts to the operating CAPE ratio and are therefore more attractive than developed markets.

“From 2011 to 2016, the emerging market currency index fell 40 per cent, partly driven by the end of the commodity super cycle and the timing of financial conditions in China,” the CIO continued.

“This index has rebounded 5 per cent from the lows but it is very much near the lows. The terms of play have improved materially as a result of that.”

He added that the recent weakness of the US dollar reflects capital flows into emerging markets as investors sell out of the US.

Performance of currency vs sterling over 1month

 

Source: FE Analytics

“If you put too much capital into the market, you destroy returns and essentially the US has absorbed a lot of capital,” Godding said. “Since 2008 there has been a record $27trn of capital injection in the US economy.

“That will diminish the returns available and it has created opportunities overseas – perhaps in Europe, perhaps in emerging markets. Capital finds a way to maximise its returns and we’re starting to see that in the performance of the dollar.

“We also have below-average valuations in emerging markets, attractive yields – particularly in emerging market local currency bonds – and a significantly lower dependence on foreign financial flows which suggests to us that emerging market equities look quite attractive.”

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