The historic vote by Britain to exit the European Union temporarily reset risk assets globally. Not too long ago, the question du jour of most investment managers was how to allocate capital in today's high-risk, low-return world.
Many client visits highlighted the consensus view that developed world equity markets are expensive, and will only deliver mid-to-low single-digit returns over the next few years. With volatility set to rise, this mindset is likely to persist, as investors focus on capital preservation.
Most seasoned investors will recognize that volatility is an excellent breeding ground for outstanding investment opportunities. In a Weekly Report published in March,1 our analysis suggested that U.S. stocks were set to underperform euro area, Japanese and Chinese equities.
This Special Report extends this analysis beyond these four core markets to a broader basket of developed and emerging equity markets. The conclusion is that although globally, equity markets are far from cheap, some compelling investment opportunities do exist.
Benchmarking Future Returns
While a cross-sectional examination of valuation ratios provides a snapshot of how each country compares to its peers, it is also important to see where this ratio stands relative to its own history. This is because valuation gaps can persist across countries even after adjusting for sector biases, due to other factors such as persistent productivity gaps, differences in the demographic outlook, and varying corporate governance standards. In general, we found a strong empirical correlation between our composite valuation indicator and subsequent market returns, whenever adequate data was available for the country.
Our composite measure is a standardized aggregate of eight valuation ratios. One advantage of using an aggregate measure is that it provides a much more accurate forecast, since it nets out some of the shortfalls from using individual valuation ratios. For example, high profit margins often suggest that a market P/E is cheaper than would actually be the case if margins were to revert to the mean. One way to strip out this bias is to eliminate the impact of margins by looking at the price-to-sales or the market capitalization-to-GDP ratio. Price-to-book ratios (and Tobin's Q) also provide a more robust measure since the replacement cost of a firm's assets is not only just frequently used value proxies at the company level, but are also subject to much milder fluctuations than corporate earnings.
Further Highlights Of The report:
- The recent selloff in global equity markets has uncovered some compelling investment opportunities. Nevertheless, very few markets are trading at undervalued extremes.
- A comprehensive analysis of various valuation metrics suggests the U.S. is among the most expensive equity markets and should be avoided.
- Most emerging market bourses are not yet cheap enough to compensate for the possibility of a prolonged deleveraging and disinvestment cycle.
- On pure valuation grounds, our most favored equity bourses are Sweden, Germany, Japan, and China, while our least favorite are Indonesia, South Africa, India, and the Netherlands.