Be selective, diversify
Intended for professional clients as defined by MiFID.
When you analyze equity valuations, they appear expensive, indicating limited upside potential over the short run. This doesn’t mean that there are no more investment opportunities in the markets. We do believe selective diversification is a source of performance today!
Equity markets are not cheap anymore
On the backdrop of increasing political risk in late 2018 and 2019, Central Banks collectively turned very accommodative, pulling interest rates down to historical low levels. In 2019, the relative resilience of the world economy, and the easing of trade tensions, have prompted investors to take equity risk as a compensation for low rates. As a consequence, equity markets have gained 25% on average depending on the geographical area compared to last year.
What else can we expect? At a first glance, when analyzing equity risk premia, equity markets remain attractive. But when we look at absolute valuations, the picture is not as glamorous.
First, long term valuation of the MSCI World - as measured by the gap of the 12-month PE ratio to its historical median - came back to its levels of early 2018 (graph 1).
Graph 1: Long term valuation – Equity markets – sources: Seeyond, Bloomberg, as of end of October 2019
Secondly, short term valuation of equity markets - measured by the difference between market performance and EPS forecast variation – indicates overvalued equities from 8% for the UK to 16% for the Euro area or Australia. (Chart 2) On average, the overvaluation reaches 12%, offsetting by three times the decline in equities in 2018. This means that a substantial recovery in profits is already priced in the markets.
Chart 2: %, Short term Over or Under () valuation - Equity markets - sources: Seeyond, Bloomberg, as of end of October 2019
Over the short run, as the end of the year is approaching, a consolidation phase, even if flat, could happen given the performance achieved on equity markets since the beginning of 2019. Does this mean that there is no further upside potential left in the markets over the coming weeks? We do not think so.
The analysis of markets’ structure highlights diversification opportunities
We carried out a Minimum Spanning Tree (MST) over the last six months to analyze the correlations between: government bonds (in black, graph 3), currency markets (in dark blue graph 3), international equities (in red graph 3) and European sectors (in pink, graph 3). The closer the markets are, the more they are correlated, positively or negatively.
The MST on global markets (figure 3) is quite spread. Correlations are globally poor. Return on diversification is high.
Figure 3: Minimum Spanning Tree on international 10-year rates (black), international equities (red), international currencies (dark blue), European sectors (pink) and fundamental data (in green)* over the last 6 months, as of end of October 2019 – sources : Seeyond, Bloomberg - *List of fundamental data included in the MST ==> us_epu : US Economic Policy Uncertainty; oil: oil price; gold: gold price; ism:US manufacturing confidence indicator; pr: political uncertainty indicator
Four conclusions can be drawn from this study:
- Equities: diversifying equities through geographical relative trades is a source of performance as countries appear very decorrelated from each other. Considering the recent performance of both US and Eurozone equities, betting that EM and Japanese equities will catch up could add value to a global portfolio. UK equities are quite isolated on the MST, meaning that they are more dependent on specific risk such as Brexit and its impact on the British Pound.
- Equity sectors: among European sectors, defensive sectors such as “food&beverage”, “healthcare” and ”utilities” are quite correlated; however “auto”, “oil&gas, and “basic resources” on the one hand, and “technology”, “industrials” and “chemicals” on the other hand constitute two decorrelated clusters. Earnings estimates and specific risk could be key to decide to invest in sectors such as “travel&leisure”, “media”, “household_goods” or “real_restate”, but these sectors definitely are good diversification opportunities.
- Currencies: investing in currencies could also be a source of performance as they are uncorrelated with equities. However, while the Japanese yen, the Australian dollar and the British Pound are finally very correlated to global rates and the US dollar, the variations of both the Euro and the Canadian Dollar are more dependent on the state of local economies and monetary policies.
- Govies: there is no point in geographical diversification between government bonds as all countries are very correlated. Nevertheless, their position at the center of the MST is sending a signal of cautiousness for 2020 regarding the potential evolution of the Fed’s stance towards a more hawkish tone in case of a deeper global cyclical recovery. Indeed, a central position is linked to huge power to influence the whole market whereas a peripheral position means limited power to influence the market. Future evolutions of global rates will be key for markets in 2020.
Despite the current easing in trade tensions between the US and China and a gradual recovery taking place, equities are not as cheap as they used to be at the beginning of the year. As a matter of fact, a consolidation, even a flat one, is possible in the short run. Diversifying global portfolios and being selective from a geographic and sector perspective on equities, and on international currencies are a solution to maintain performance capacity as markets structure points to low correlation.
Written by Stéphanie Bigou, Seeyond Portfolio Manager, November, 9th 2019
This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in this article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.