Money
Issue No. 29 - June/July 2006
[Valuation – risks are shifting]
by Mr Marcus Campbell
The increase in bond yields over the past weeks has reversed the relative attractiveness of industrial equities compared to bonds. The Bond Yield/Earnings Yield relationship has reversed towards the long-term average of 1.05, significantly higher than the more recent average of 0.82 established since the beginning of 2002 (post 9/11 when deflation risks were increasing).
Some will argue this move is long overdue and reflects a more appropriate risk premium being priced into bonds; we believe the other implications worth highlighting are:
Equities are less attractive as the preferred asset class. One of the key drivers behind the strong rally in equity markets has been its attraction relative to other asset classes, in particular bonds, combined with strong liquidity flows.
Absolute valuation risks are increasing. Increased bond yields increase the implied cost of capital used in discounted cash flow valuations as the risk-free rate (used for cost of equity and cost of debt) increases.
Yield attractiveness is reducing. The market's attractive dividend yield, has been in line with bonds on a grossed-up basis.
Multiple expansion risks are increasing. While most of the market's strong performance since early 2003 is due to earnings growth, the more recent strength in Industrials has been more due to P/E multiple expansion.
The key themes we anticipate for the second half of 2006 and 2007, which have been driving our sector allocation for domestic equities, are:
The domestic economy will strengthen, driven by greater consumption, business investment and housing activity.
The US economy will slow as US housing activity slows, with a pull-back in mortgage equity withdrawal and a corresponding slowdown in consumption.
Global growth momentum outside the US will stay strong, particularly in China and Japan as growing domestic consumption offsets the impact of slowing US consumption.
The US dollar remains...
