Today, most investors are at a loss regarding what to think of the notion of value and valuations and, even most importantly, how to use it in portfolio construction. We are at the start of a sort of crisis in confidence regarding valuations (and therefore also fundamentals, as they are interlinked) because few to no valuation indicators seem to be effectively working and irrational forces are perceived to be taking a prominent role in driving financial markets. There is a great disconnect between financial markets and the real economy.
The temptation is to give up on value/ fundamentals as a founding investment principle or to just consider short-term relative equity/bond valuations instead of more strategic absolute metrics.
Valuation metrics Indicators
Yet, we argue that long-term absolute valuations are key to building a strategic asset allocation and they are even more relevant in an era of possible regime shifts. What investors need is to further enhance their approach to absolute valuations.
In this respect, we believe they should enrich the traditional approach based on (real) fundamentals (inflation, growth, earnings) with the inclusion of a monetary factor (as a dominant feature of the current transition phase) and narratives as a foundation of long-term expectations. Real fundamental factors, though less prominent in this (monetary oriented) regime, are not less relevant from a valuation perspective if 1) they are approached with a long-term, non-cyclical view in relation to expectations and 2) if they are broken into facts and narratives.
Narratives are adding (or subtracting) to a trend, reinforcing it or pushing it in a different direction. For example, the narrative of low growth/no inflation (secular stagnation) has shaped long-term expectations over the past decade, because it has been public, vocal and visible. Moving forward, the emergence of a ‘back to the ‘70s’ narrative can help modify long-term expectations even before (or beyond) what data shows. This is why it is important to capture the dynamics of narratives and the emergence of new ones as they can help explain a deviation from equilibrium (by equilibrium we mean what is coming from fundamentals as defined by expectations on growth/inflation/earnings). Therefore, we could enlarge the notion of equilibrium to include all the three pillars (monetary factor, real factors and narratives) as explanatory factors. Combining these three pillars can help design scenarios and portfolio actions within a regime and across regimes.
At the same time when there is a deviation from equilibrium and a prevailing narrative signaling a change in regime, this points to an important turning point for investors: this is exactly what we are facing right now.
In the second half of the year, we will likely reach a decisive moment with the acceleration of the vaccine distribution, the reopening of economies and the possible initial effective signals of accelerating growth and some inflation pick-up.
At this point, the current narrative of low growth/no inflation forever will be tested.
This will confirm the dominance of the narrative pointing down the road to the 70s. In fact, today, in the transition phase towards a different regime, for the first time in more than three decades narratives are explicitly expressing a preference for inflation as a way out from the current crisis. In these narratives, inflation has ceased to be a negative. It is a desire. This will likely drive the materialisation of a higher inflationary regime.
When a preference across society and its institutions is being established, experience shows that the prevalent narrative becomes self-fulfilling and this often leads to a new mandate given to central banks. Former Federal Reserve (Fed) chair Paul Volker got his mandate to fight classic inflation when he was appointed in the late 70s. The new generation of central bankers will be asked to address new conflicting challenges, such as absorbing skyrocketing debt while dealing with an asset bubble generated by an excess of liquidity created by central banks themselves. The transition phases unsurprisingly see the co-existence of previous and new mandates. The reassessment of these narratives, and of value, will be a key input when revisiting portfolio construction and it could also offer investments opportunities.