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How valuations drive returns, and why bonds are set to thrive
Valuation – essentially, whether an asset is expensive or cheap – is a key but easily overlooked investing concept that, while not a perfect guide, can be a good indicator of medium-term return potential. According to AMP’s Shane Oliver, starting valuations today support an improving outlook for cash and bonds, while equities will likely need inflation to fall first.
“It’s logical that the cheaper you buy an asset, the higher its prospective return might be,” the chief economist (pictured) wrote in a recent note. “However, this is frequently forgotten, with investors often tempted to project recent returns into the future, regardless of valuations.”
Cash is an example of an investment where the starting point matters critically, Oliver said. As the Reserve Bank of Australia has pumped up the cash rate over the past year, term deposits have offered better return potential.
Government bond yields in advanced countries are also valuation starting point that helps show medium-term return potential. High bond yields set up high medium-term bond returns, and vice versa; a similar relationship applies to shares.
“That means when share prices are high compared to earnings, subsequent returns tend to be low, and vice versa,” he added. Thus, the best time to invest in shares is after price-to-earnings (PE) ratios have dipped to single-digit levels.
“The key is that the starting point matters – put simply, the higher the yield and the lower the price-to-earnings ratio (for shares) relative to their history, the better for an asset’s medium-term return potential.”
‘Cheap for a reason’
While valuation is important, Oliver stressed, it isn’t a “perfect guide” to returns and can come with its own pitfalls.
For instance, it’s important to allow for risk, he said – “sometimes assets are cheap for a reason”, as with a tobacco company with attractive current earnings that’s facing a slew of lawsuits.
Valuation is also a poor input for attempting to time the market, and “there is a huge array of valuation measures when it comes to shares”, Oliver said, with multiple possible interpretations of “earnings” in the PE ratio, all with pros and cons.
And, he explained, “the appropriate level of valuation will vary with inflation and interest rates”, meaning assets can trade on lower yields in times of low inflation as uncertainty falls but that rising inflation and rates would cause shares to trade on lower PE ratios – a major factor in sharemarket underperformance last year.
Outlook ‘far more attractive’ – for some asset classes
Turning to what starting valuations indicate today, Oliver noted that cash and term deposit rates, at around 4 per cent, are “far more attractive than was the case two years ago” but still below the inflation rate. The same goes for bond yields, which points to improved, albeit still constrained, medium-term return potential.
As for equities, PE ratios point to a potential medium-term return of about 10 per cent for Australian shares, compared with just 5 per cent for US shares.
“Allowing for the rise in bond yields – by subtracting 10-year bond yields from the earnings yields (using forward earnings) – shows US and Australian shares now offer a reduced return premium over bonds of around 0.8 per cent in the US and 2 per cent in Australia,” Oliver said.
“For the US, this is the lowest risk premium over bonds since after the tech wreck, whereas current uncertainties (around interest rates, recession risk and geopolitics) suggest the risk premium should ideally be higher,” he said, although the risk premium is more attractive for Australian shares.
Ultimately, bond yields will likely need to fall for the outlook to improve for equities, which hinges on inflation continuing to cool.
“But in the near term, the risk of a further correction in sharemarkets led out of the US remains high, reflecting the deterioration in US share valuations, particularly for tech stocks, which are very sensitive to bond yields,” Oliver concluded.
