The market environment

• We continue to face de-synchronised global growth.

• Cheap money forces investors along the risk curve in search of returns and this dynamic continues to bolster asset prices.

• "Defensive" equities are becoming ever more expensive. Their yields and their stability (real or perceived) remain attractive in a near zero interest rate world.

• US equities have outperformed, such that there is now a significant valuation divergence between the US market and rest of world.

• Commercial property continues to make gains, as investors view the yield as compelling compared to the risk-free rate, despite the illiquidity in the asset class.

• Meanwhile, sovereign bonds are indicating a very sluggish and deflationary environment.

• Despite enormous levels of monetary stimulus, the brutal truth is that the global economy has failed to reach “escape velocity” and central bankers around the world are going into overdrive to ignite/ support growth.

The harsh reality

• If you believe that near zero interest rates are a permanent feature of the economic landscape, then the demand for income-generating assets is logical.

• Put simply, investors are willing to pay ever higher valuation multiples for positively yielding assets.

• Unfortunately, this brave new world challenges the traditional valuation models for all risk assets and we see this reflected in the growing sense of unease shown by fund managers.

• Equity managers face a world where earnings growth is at best muted and yet they are being asked to pay ever higher multiples of earnings and cashflow for stocks they already deem expensive.

• We must re-emphasise that there is a growing sense of discomfort amongst all sections of the fund management community about valuations in the majority of risk assets.

What to do?

• We expect to see even greater volatility this year, as investors try to navigate the contradictory signals from the markets.

• For more pro-active investors, taking advantage of volatility and buying on dips in equities may be a profitable exercise in the first half of the year.  For the second half of the year, we expect that a more cautious strategy may be in order as certain realities come home to roost.

• For new investments, if you are concerned about market direction and volatility, we favour exposure to diversified absolute return strategies and possibly dedicated long/short equity funds (see our IA Sector Overview for the Targeted Absolute Return sector).

• We retain our scepticism around the majority of absolute return fixed income strategies.  If you are nervous, we suggest higher cash weightings rather than significant exposure to low yielding fixed interest funds.

• Be aware that the valuations of defensive equities are pushing multi-decade highs. This is a function of the hunt for yield, which persists, but the longer this goes on, the more likely it is that we will experience higher levels of capital volatility as value drains away from equity prices.

• We remain cautious for the year as a whole.  We acknowledge the power of liquidity but it is unnerving that, more than ever, the pricing points for risk assets are at the behest of policymakers.  As such, we would suggest that investors proceed with care!