Market Solutions November – Get real: the divergence between financial and real assets cannot persist indefinitely.

By Rob Price on Dec 18, 2017 in ESG Matters

Equity markets across the globe have continued to surge higher in 2017. To the end of November, the All Share Index had returned 22.5% over the past year in rands, while the MSCI All Countries World Index (ACWI) returned 20.3%. Strong gains are fantastic for the majority of pension fund investors as portfolios are predominantly invested in listed equity. However the gains have also pushed valuations on many indices into uncomfortable territory. Equity valuations in the United States, the world’s biggest economy and dominant financial market, are particularly concerning. Any of the traditional valuation measures indicate elevated valuations. Expensive valuations do not automatically imply that shortterm gains cannot remain strong, but subsequent long-term returns are expected to be weak from these levels. Weak long-term returns must concern investors who are mainly concerned with long-term retirement goals, not short-term market movements.

Overvaluation isn’t confined to the equity markets, and it’s not just a US phenomenon. We focus on the US due its size because if it experiences a proverbial cold, so does the rest of the world.

US household assets are currently valued 6.5 times higher than disposable incomes, which is the highest level on record. Equities, property and bonds are the main drivers. This divergence is indirectly due to economic policies implemented since the 1990s, which attempted to target higher house and equity prices with low interest rate policies in the hope these gains would “trickle down” to the rest of the economy. Instead we have witnessed a steady rise in financial asset valuations (equities, bonds and listed property), and limited response from real incomes, leading to the increasing divergence between the “haves” and the “have nots” in society. Another outcome of extreme economic policy is the divergence between financial assets and real assets, such as unlisted property, private equity and commodities, which are more tightly linked to real economic activity.

Being long-term investors we’re interested in this divergence and are trying to mitigate performance risk by diversifying into these “unloved” asset classes. History tells us that these kinds of divergences cannot continue indefinitely and there are reasons to believe normalisation is possible in the years ahead. There are a number of major central banks attempting to pull back from monetary stimulus with Quantitative Tightening (QT), the new catch phrase in the markets. Allied to this, policymakers are taking increasing exception to the levels of wealth inequality that have emerged, and it wouldn’t surprise us if economic policies shift in a direction more favourable for real assets.

While the continued strong performance of equity markets is an encouraging feature of pension fund statements, it also provides another reason why we’ve included private equity in certain portfolios and are making use of risk mitigating strategies such as hedge funds. These strategies will benefit as the world shifts from financial towards real assets in the years ahead. We will continue to build on this theme in the New Year and find new strategies to improve risk-adjusted returns for clients.

Rob Price

Rob Price

Rob Price heads up asset allocation within the investment team. In short, asset allocation determines which asset classes are appropriate for a client’s risk and return objectives and at what percentages we should allocate to each asset class. This outcome a critical aspect of the investment process and a tool through which Alexander Forbes demonstrates its risk management approach. Rob is a trained economist and a CFA charter holder but he believes that the best education isn’t necessarily found in the classroom. He loves all things macro, appreciates ideas that challenge the status quo and is relentlessly in pursuit of practical answers to difficult questions.

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