Forecasts for growth in 2018 are positive, however many valuations in equities and bonds appear elevated. But Legg Mason’s managers still see potential to uncover value in global markets for investors.
As economic growth worldwide makes the transition from being artificially fueled by central banks to being sustained by improving economic fundamentals, investors are seeking to identify sectors and companies that will potentially benefit from the transition.
While major central banks are beginning to pull back from their ultra-accommodative stances, our Legg Mason managers believe that they are likely to continue with a cautious approach in 2018, recognising that the pace of growth will be less-than-torrid — and therefore helping to moderate the impact of rate hikes on the markets.
The question, of course, is how much future growth is already priced into stock and bond prices. The relatively muted sentiment our Managers see relative to stocks suggests that the markets could have additional room to run, assuming that earnings growth keeps pace. But with that less than certain, the flexibility and selectivity of active strategies will allow investors to target sectors and securities whose prices may not reflect their true potential value.
"Across asset classes…valuations have been grinding higher: nothing is cheap"
What can investors do?
Active strategies with a flexible and selective approach allow investors to harness growth and limit losses in a slow-but-steady growth, rising rate, high valuation environment.
- Global shares: Given the Australian share market is only 2% of global share market capitalisation1, there are clearly growth opportunities available in offshore markets. Whilst the US has performed strongly in recent years, QS Investors believes there are still opportunities in other developed share markets, particularly those with steeper yield curves : “Investors can learn a lot from yield curves. Steeper government bond yield curves often precede strong stock market returns. Lower short-term rates can stimulate the economy and larger long-term rates can be an indication of investor’s expectation of rising inflation and stronger economic growth.”
- Emerging market shares: U.S. equity prices are already elevated, with price/earnings ratios (P/Es) in the low 20s after an average 13.5% annual gain for the S&P 500 since the end of 2009. By contrast, emerging market equities (MSCI EM Index) have returned only 4.0% p.a. over the same period, with a P/E of 16x, making them look relatively attractive. Global manager Martin Currie sees emerging markets as the main driver of opportunity, “benefiting from strong growth in infrastructure, ‘plain vanilla’ banking services, e-commerce, entertainment and convenience”
1 Based on MSCI World Share Market Index, Bloomberg, 20/12/17
Emerging share markets – more room to run in 2018?
S&P500, MSCI Emerging Market
Source: Bloomberg, 1/12/2017, Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment
- Australian credit markets: Western Asset’s conviction is that spread sectors should outperform Australian government bonds : “…monetary conditions remain extraordinarily accommodative even as the major central banks discuss or cautiously commence the removal of emergency policy settings. We believe such conditions still favour spread sectors as investors seek yield. These sectors should be the best-performing fixed-income assets and continue as our major theme.”
- Global credit sectors: Brandywine Global believes that within global credit markets over the past year, valuations have stretched to extremes and credit spreads have tightened: “The challenge for credit investors will be how best to position for a scenario where economic activity continues to improve but valuations in certain sectors already fully incorporate this positive information risk.” For global investment-grade and high yield, Western Asset’s focus is careful name and industry selection, given that spreads are already compressed. In investment-grade, it prefers “rising stars” - lower-rated issuers that are working to reduce debt, moving toward greater creditworthiness. Agency mortgage securities also may offer a source of return with somewhat reduced volatility. Western Asset considers this asset class to be misunderstood, but notes that its fundamentals have improved. In their view, the U.S. will remain in a slow growth environment and the U.S. consumer continues to be the strongest part of the economy. In particular, Western Asset believes U.S. house prices are projected to grow at 2%-3% over the next 1-2 years and commercial price appreciation is expected to slow but remain positive. As well as this increased banking regulation and the constrained lending that has followed has led to an improved quality of credit in this sector.
- Emerging markets debt: Both Western Asset and Brandywine Global see this asset as a superior opportunity for return. In particular, debt denominated in local currencies in countries like Brazil and Russia that have high real interest rates, falling inflation and improving growth. What’s more, “emerging market valuations also look attractive both on a historical basis and relative to developed markets, particularly given a better global recovery, lower risks in China and commodity stabilisation.”
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Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
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