Last week’s British vote to exit the European Union (EU) has spurred a flight to perceived safety and left many investors asking where to find opportunities amid indiscriminate selling of global risk assets. This week’s chart helps explains where to potentially find attractive value in a post-Brexit world.
Prior to the Brexit vote, there was a wide range of valuations but few cheap assets globally, as shown in the chart below. With most asset valuations still looking fair to expensive, it’s important to focus on relative valuations.
Modest economic growth, low inflation expectations and easy central bank policies have sent yields lower, intensifying flows into income-oriented assets. This partly explains extreme valuation differences between equities and government bonds. Political concerns in Europe have exacerbated other extreme differences, such as that seen between international stocks and U.S. equities.
Valuations tell us little about short-term returns but can potentially shed light on medium-term returns. Starting valuations explain roughly 10% of U.S. equity market returns over the following year but 87% of returns over the next 10 years, according to our analysis back to 1988.
Valuations also show the risk of owning bonds (and bond proxies) could rise further, as market uncertainty and easy monetary policy potentially drive valuations of interest-rate sensitive assets higher. Some assets may be cheap for a reason, reflecting structurally challenged businesses, for instance.
The big takeaway for investors
The big takeaway for those seeking to buy into market weakness: Be wary of buying notionally cheap assets that face challenges (e.g. domestically-focused European assets like U.K. real estate and European banks), and instead focus on assets with relatively attractive valuations and positive fundamental drivers, such as quality stocks, dividend-growth stocks and investment-grade bonds. Indiscriminate selling of risk assets could translate into buying opportunities in these assets, including in U.K.-listed stocks that benefit from pound depreciation (72% of FTSE 100 revenues are earned abroad).
Selectivity and caution are key
Bottom line: Post Brexit, selectivity and caution are key. Read more market insights in my weekly commentary.
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