Fair value - Investors must rethink investment returns post-recession

Many investors are tempted to focus on short-term price moves rather than looking at current prices in the context of their long-term valuations. So what returns can investors expect from the different asset classes?

Most domestic asset classes are currently fairly valued. This was not the case, for example, at the worst of the financial crisis, when equities were cheap relative to their long-term equilibrium value.

Determining fair value

“Using a long-term equilibrium return framework to help us to stay as grounded and objective as possible, we look at different asset classes and decide what sort of return rational investors should demand from those asset classes over time,” says Michael Moyle, Portfolio Manager at Prudential. “It is independent of a particular valuation starting point but takes into account the current economic environment.”

This return framework is defined in real terms, i.e. returns in excess of inflation and by long-term or equilibrium returns over ten years - long enough to look through cycles. Various macroeconomic cycles and market variables experience peaks and troughs within a period of ten years.

“The equilibrium returns are based to a certain extent on what asset classes have delivered historically, but they are also forward-looking. These equilibrium numbers are set in the context of a global framework with input from Prudential colleagues iaround the worldn the UK, in America and in Asia,” explains Moyle.

Expected equilibrium real returns

Graph 1 shows the expected equilibrium real returns for various asset classes. For example, Prudential believes that South African government bonds should have an average real yield of 3.5% over the next 10 years.

Graph 2 includes the current asset class valuations. The required real returns are shown for the different asset classes in black. The red bars and numbers show the current valuations and therefore provide the overlay of where we are today. If the red bar is above the grey line, the asset class is cheap or attractive, which means that investors are being overcompensated for the risk that they are taking in that asset class. The reverse is true if the red bar lies below the grey line.

   (Click to enlarge)

“This is an indicator of whether different asset classes are currently cheap or expensive and therefore in the context of a diversified portfolio, whether investors should be overweight or underweight that asset class,” comments Moyle. “It is important to note that this methodology merely focuses on current valuation and is not some kind of magical ‘black box’ that tells you when to buy or sell assets.

Cash is expensive and all other asset classes look attractive relative to cash, but there is risk in that they, with the exception of corporate bonds, are not cheap on an absolute basis. Corporate bonds look attractive as corporate bond spreads are above average levels.