The valuation battleground
For the last two years or so we have seen the world’s equity markets as a battleground between valuations which by traditional standards were extremely high and the forces of liquidity, which have been producing ever-increasing cash flows for the institutions and enabling the corporate sector, far from issuing new shares to investors by way of IPO’s and rights issues, to be a net buyer, whether by way of buybacks, special dividends or take-overs for cash. So far, we have felt that the liquidity flows were likely to prove the more powerful, and we have therefore largely ignored the message given by traditional valuation criteria (such as high P/E ratios and low dividend yields) that equities were dangerously overvalued.
The other hugely influential factor has been the shift from inflation through disinflation to (possibly) deflation. This process has led to a huge fall in long term bond yields. It is perhaps hard for people to remember that in early 1982, less than 20 years ago, long yields in Britain were over 16% and in America over 14%. Now we think it unremarkable that they should be below 6%.
Looking ahead rather than backwards, we think that the forces of liquidity will continue to have the upper hand for at least the next year, and accordingly we prefer to remain overweight in equities, which appear to be the asset of choice for the maturing baby boom generation.
Within this asset class, from a UK investor’s perspective we prefer UK equities on the grounds that it is clear that the economy, after the reforms (however painful) of the Thatcher years, is performing much better than it has for at least a generation. On top of that, the British authorities, whether the Treasury or the Bank, have more room for manoeuvre if growth in 1999 disappoints than their counterparts in other countries. Our allocation to UK equities for balanced pension fund accounts is therefore 59% of the total fund, despite the fact that, in aggregate, profits may fall again this year.
Internationally like everyone else we have been attracted by the arguments for Europe - the relatively early stage the Euro economies are at in the economic cycle, the huge scope for restructuring in the corporate sector, and the relatively low rating of shares. However, economic growth is tending to disappoint, especially in Germany, and investor expectations are high, and we are holding only 9% of funds in Europe, somewhat less than our competitors, fearing that profits may fall short of expectations.
As for as the Far East is concerned we are agnostic, in Japan as far as restructuring is concerned and in South East Asia as far as recovery goes. In aggregate we have only 4% in the region, well below the levels of earlier years.
America remains the great enigma, the epitome of the liquidity/valuation struggle. Shares in general have never been so highly valued, either in absolute terms or relative to bonds. Yet the forces that have produced this situation remain as strong as ever. Our weighting here is 4.75%.
Bonds we feel are no more than fair value, with gilts at 4.5%, bonds at 4% and Treasuries at 5.5%. We do feel that US TIPS (index linked) on a real yield of 3.75% are very attractive relative to all other asset classes, but holders of them are in danger of dying of boredom as prices never seem to change! Overall, we have a neutral weight in bonds.
Richard Burns is with Baillie Gifford in Edinburgh