Which investment markets are attractive right now… and which are not?

Quite a bit of media attention has been around the subject of equity and property markets being quite expensive at present.  For the most part, we are not overly concerned in the context of the longer time horizon.  There are some markets that appear stretched, but overall there are many relatively attractive markets in which to invest.

Australian equities are attractive

We believe that Australian equities are favourably priced and offer attractive returns of the order of 9% p.a. over the next decade. The last time we considered Australian equities to be expensive was in December 2007 – around seven and a half years ago.
In comparing the Australian market today with that of 2007 there are a number of differences:

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Today, over seven years later, we have lower prices, higher dividends and more attractive prospects for profit growth.   And, perhaps most importantly, today the cash rate is at 2% p.a. – almost 5% lower than it was back in 2007.
When we think about how attractively valued equities are, we look at both what sort of returns we can expect and what we can get from low risk alternatives such as cash or term deposits (TDs).  Today the difference is significant between our circa 9% p.a. forecast returns for Australian equities and cash returns of 2% p.a.  Our forecasts are not perfect, but that is a very big margin for error.
Most major international equity markets are similarly attractively priced.  We forecast returns in a range from 8 to 10% p.a. for Europe, the UK, Asia and the emerging markets for the coming decade.

US equities are far from cheap

There is an exception.  The US market is not expensive but in our view it is not offering sufficient return for the risks involved.  The 2007 to 2015 comparison for US equities shows a very different picture to Australia.

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Higher prices, lower dividends and lower prospects for profit growth make the US market much less attractive.  The only real support comes from the very low interest rates in the United States – and even those should begin to slowly rise over the next 12 to 24 months.

Australian commercial and residential property offer very different prospects

We see a similar dichotomy in the property market. We believe commercial property is relatively attractive at present.  With income yields in the order of 5.0% to 6.0% p.a. and the potential for rental growth at around the same rate as inflation, selective opportunities in commercial property can offer potential total returns of 7% to 9% p.a.  Again, well in excess of returns available from cash and TDs.
The listed property trusts (LPTs) have experienced a strong rally in prices over the past year and may be due for some consolidation. Unlisted commercial property has also experienced a rally but not of the same magnitude as LPTs.  Consequently, we see selective opportunity in this sector but it is very much on a case by case basis.
Not so with residential property, which we believe is stretched, particularly so in the areas of Sydney and Melbourne and is likely to produce only modest returns for some time.  With net rental yields of 2 to 3% and only modest prospects for capital growth following the recent strong increases in prices, we think the outlook going ahead for a lot of residential property is of the order of total returns of 3 to 4% p.a.  Not much better than TDs.  And this is before the substantial costs associated with buying and selling residential property.

Bonds look good for the secure part of the portfolio

After spending the past few years urging investors to lock in long-term term deposits (TDs) at rates of 7%, then 6%, then 5% and, as late as last December, at rates over 4% p.a. for five years, we have changed tack.  We previously recommended long-term TDs because they paid much higher returns than cash and bonds and because we did not believe interest rates would rise sufficiently to cause investors to regret locking away those high rates.  That has now changed.  The rates on government bonds have risen, as have rates on corporate bonds and both now offer as attractive returns as TDs but with greater liquidity.
We remain unenthusiastic about cash.  Currently at all-time lows, we believe cash rates may go even lower in coming months and are unlikely to rise much above 2.5% for the next three years.

The Tipping Points

Our Tipping Point chart summarises the longer term prospects for the major markets. Markets that are classified as cheap are forecast to produce returns that beat term deposits (TDs) by 5% p.a. or more, those at fair value are forecast to give returns between 2.5% and 5% p.a. better than TDs, whereas fully valued assets are forecast to beat TDs by less than 2.5% p.a., and overpriced assets are forecast to produce returns below those generated by TDs.
The standout observation from this chart is that Australian shares appear to have a fair amount of headroom left in terms of capital growth before we should become concerned about their long term valuations.
The same applies for most international share markets with the exception of the US market as highlighted above.

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by Tim Farrelly, Principal – Farrelly's Investment Strategy (Reproduced with permission)