Whilst we remain confident in the ability of equities to continue to deliver attractive real returns for investors over the long term, there is no doubt that care is needed in the current financial markets. First and foremost, quantitative easing looks to have created asset bubbles in certain areas of the market - most notably in conventional fixed return assets (when vast swathes of bonds trade on negative yields, it is not hard to determine that the long-term returns from this point will be poor) but also in certain areas of the equity market.
US equities, for example, have enjoyed an exceptionally strong run of outperformance since the nadir of the financial crisis in March 2009. However, a significant part of this outperformance has come at the cost of increasing valuation risk. Indeed, the valuation discrepancy between the US and other major equity markets is now striking. European equities, for example, currently trade at a discount to their US counterparts that is close to historical extremes. There are of course good reasons for this – economic growth in Europe is slow to non-existent (despite negative interest rates in many European countries) and the EU looks ever more like something of a failed experiment. However, one of the most counterintuitive aspects of investing is the fact that bad news is almost always required for things to get cheapenough to create good long-term investment opportunities. From this starting point a reversion to mean would result in underperformance of the US market for a period.
Having said this, it is worth noting that fundamentals in the stock market do not work to a set schedule and assets can remain cheap or expensive for extended periods. The challenge for us as investors is to balance the merits of quality and value within a diversified and resilient portfolio.
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