One of the topics asset allocators are grappling with at the moment is whether asset class valuations are expensive or not. Whether you are an active asset allocator, or an active bottom-up stock picker, valuation will most likely be at the core or at least form part of your analysis when making a decision to enter or exit an investment. Valuation historically has been a good long-term metric in assessing the potential future return of an asset. However, with interest rates at depressed levels, asset prices that are expensive based on historical levels, don’t appear to be that expensive given the low interest rate environment. Equity markets in general and growth companies, in particular those that are expected to grow their free cashflow in the future, have benefited from the low interest rate environment as they tend to be more sensitive to interest rates akin to a long duration bond. It could be argued that if interest rates remain at low levels (and possibly lower) risk assets will continue to benefit. Despite this we believe that at some point markets will focus on fundamentals and that the market will need to demonstrate earnings growth to sustain valuations. Furthermore, studies suggest that the relationship between interest rates and valuations is not linear, meaning that markets benefit from low interest rates to a point.
From an asset allocation perspective, valuation remains an important tool to help make active asset allocation decisions. We believe that in the current environment you also need to consider medium-term signals such as where we are in the cycle, liquidity and sentiment, as these factors can influence the extent to which asset prices can remain elevated or depressed for periods of time.