On Markets’ Valuation

This is my weekly column on Forbes.fr
It is available in French here

Here is the English version

The financial markets are carrying high prices in industrialized countries and this makes for some seriously tough choices for investors who want to invest their capital. Very low interest rates mean very expensive bonds. Meanwhile, the equity markets have recently staged a spectacular rally, particularly in the US after Donald Trump’s election. Seeking to invest savings on markets that are already expensive or very expensive is a difficult and complex process. In the past, we have always seen a wide range of assets with vastly differing valuations, so choices were easier as there were often assets that had been neglected by investors and carried a discount. But things no longer work that way for a number of reasons.

The first reason is that behind the markets’ current profile lie the central banks and the impact of their intervention. These institutions have been implementing accommodative measures for a long time, with very low interest rate structures. The aim behind these moves was to reduce savers’ temptation to transfer their wealth to the future by creating incentives to spend it in the present, with the ultimate aim of bolstering economic activity in the here and now to try to set it onto a more robust path for the long term.
When bond returns are low, investors are in no rush to invest their cash in this asset class and this explains why the number of current accounts held by banks soared spectacularly. The ECB’s asset purchase program is intended to promote spending in the present rather than in the future and by taking this action, the European institution legitimizes the fact that its aim is primarily to foster economic activity.
The central bank’s monthly €80bn bond purchases (to be cut back to €60bn as of April) are pushing prices up and leaving interest rates very low. Under these circumstances, who would want to invest in assets that already carry very high prices? And so investors need to look at other assets if they are to find yield, and this often involves taking on excess risk exposure in order to achieve acceptable returns across the entire investment portfolio. The breakdown between equities and bonds within the portfolio is therefore severely weighted towards equities and this is one of the drivers behind the stockmarket rally.

We are now witnessing the limitations of this system: the shift into risky assets was an effective move, but all assets are now pricey and this makes asset allocation more complicated. And to top it all off, investors are not keen on taking this type of risk. Not all investors are indifferent to risk, and many of them do not want to take risks that they deem to be excessive. High prices on the markets put them in a tricky position of having to take extreme risk in return for yield.
This situation is therefore prompting investors to move towards other investment opportunities, for example emerging market bonds. Investors’ choices are not merely dictated by the economic improvement in these countries, but also by a lack of viable alternatives in the asset classes currently available. 

Yet this explanation is not entirely satisfactory. The equity markets are very expensive in developed markets due to these excess savings, while companies are not investing sufficiently to warrant these valuation levels. Corporates are not taking the necessary steps to sustain their profitability in the long term and it is therefore unreasonable for their valuations to be so demanding. An explanation for this phenomenon can be found in the gap between the location of funds for investment and the location of production. The average age in industrialized countries is higher so residents tend to hold more savings, while several emerging countries have younger populations but boast fast-rising production. However, financial markets in these emerging zones are not sufficiently mature and display a development lag as compared to the financial markets in western countries.
This means that savings in industrialized countries cannot be massively invested in emerging markets as investment vehicles are neither extensive nor robust enough and these financial markets themselves lack depth and liquidity. Investors will only add a dash of emerging markets to their asset allocation, yet the economy of tomorrow is developing in these very countries.

Until very recently, there was a coherent relationship between investment and production location. Asset valuations reflected this situation as during periods of higher growth, corporate investment rose sharply. The improvement in profitability in the longer term therefore justified allocation into risky assets.
In our current world, investment and corporate expansion are now primarily taking place in emerging markets, so investors should invest more in these regions. However, financial markets in these countries lack the necessary maturity for financial investment to be able to match future production projections.
We are most certainly in the throes of transition. Growth in production and production capacity, along with increasing innovation will grant these emerging economies an even more decisive role in driving global growth in tomorrow’s world. Their currently underdeveloped financial markets will gradually become more mature. This process will take time and will probably involve some impressive market adjustments along the way.
Until such times as this maturing process takes place, we will probably have to learn to live with expensive (over-expensive) markets in western countries in relation to their production outlook. We will only strike a satisfactory balance again when emerging countries have financial markets that can accommodate capital from right across the world…and then will begin a new era.


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