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Contents
Key points
- Gains in risk assets have been driven by an expansion in valuations rather than an improvement in fundamentals, which tempers our outlook across public markets for the medium term.
- A core challenge in forming a grounded outlook is recognising the distinction between price and value – and how that relationship can evolve; this is why we draw on a broad suite of models and valuation frameworks designed to anchor our thinking in fundamentals.
- Our approach is shaped by the mantra that there is one realised past, but many potential futures – this underpins our comprehensive approach to analysing potential risks and opportunities.
Author
Ben Troke
Senior Investment Strategist, LTIS Capital Markets Modelling
Lighthouse home
Price vs value
We’re believers in the view that while sentiment, momentum, and the emergence of new information can drive asset prices in the short term, it’s ultimately fair valuations that shape returns over longer time horizons.
The challenge is recognising when price and value meaningfully diverge, during what can be prolonged periods of irrational market exuberance or pessimism – it’s not uncommon for markets to behave in ways that appear disconnected from fundamentals. Arguably, prudent forward‑looking investing depends less on how quickly one reacts to price, and more on how effectively one can weigh underlying value. After all, price is observable – value must be determined.
One past, many futures
In a fast-changing world, where the only certainty is uncertainty, a key tenet of our overall investment philosophy is that there is one realised past, but many potential futures. This is why we devote significant time and resource to analysing and calibrating qualitative as well as quantitative scenarios, including optimistic and pessimistic technology cycle scenarios, fiscal risks and geopolitical escalations.
The setting of strategic asset allocation requires a long-term perspective, and for us the starting point is to establish a sense of where the long-term anchor for expected returns sits across different asset classes based on their underlying characteristics, the prevailing level of interest rates and the required risk premium in equilibrium. This provides the starting point for our asset class views.
In practice, markets and economies are rarely in equilibrium, so we must consider our starting position with respect to economic cycles, market valuations and prevailing trends. This approach builds on our view that markets are, at best, only semi-efficient. While investors seek to value securities based on expected cash flows, asset classes have differing levels of certainty around those cash flows which drive varying levels of volatility. Investors must explicitly or implicitly make assumptions around the growth trajectory of those cash flows, or the certainty of them in the case of debt-like instruments.
Different assets – different toolsets
The central challenge for any valuation framework is to establish a sensible anchor against which current market prices can be assessed. In practice, valuation is as much an art as it is a science; there is no single definitive method for projecting future cash flows, and each approach carries its own assumptions and limitations.
At their simplest, value assessments may rely on backward‑looking measures such as earnings or book value. However, most long‑term investors ultimately seek some form of fundamental value – whether grounded in historical metrics in the case of value investors, or forward‑looking expectations of cash‑flow growth in the case of growth investors.
Valuation estimates have varying performance in the prediction of subsequent asset class returns:
- For fixed income, starting yield is often viewed as a good predictor of future returns. This can be further enhanced with the estimation of roll down depending on the shape of the yield curve. For investors with a clear long‑term view on where yields are headed, anticipated changes in yields can provide valuable insight into expected total returns.
- In corporate credit, the starting level of spreads relative to government bonds offers a useful guide to potential excess returns. This matters in today’s environment, where spreads across much of the market have compressed. Although factors such as shifts in credit ratings bands, or the strength of corporate balance sheets can influence outcomes, spreads this tight have historically been associated with weaker excess returns.
- For equities, there is a broad spectrum of valuation approaches, reflecting the significant uncertainty inherent in this asset class. Whilst some see benefit in using long-term trend estimates of measures such as earnings or book value, others prefer to derive value by discounting projections of future cash flows. Both approaches have their merits and their drawbacks, the former relying on mean reversion, the latter better capturing structural shifts but also vulnerable to extrapolation. Both tend to perform less well over shorter term horizons of under three years, exhibiting better predictive power over a much longer timeframe.
Subsequent US equity returns versus starting valuations over different time horizons
Regardless of asset class, the trade‑off between predictive power and time horizon underscores the challenge for investors aiming to take a long‑term approach. Ultimately, the long term is made up of many short‑term periods, and investors relying solely on valuations can experience extended stretches where markets remain “wrong” relative to their assessment of fair value. For fixed income and equities, the starting level of valuations generally have a poor predictive ability in the short term. However, at time horizons of five years or more they offer a useful indication.
A spotlight on our valuation framework
We believe that choosing the right valuation anchors is essential for building a grounded perspective – one that looks beyond, but doesn’t disregard, immediate momentum. Our medium term assumptions draw on two key inputs: (1) estimates of an asset class’s starting valuation, and (2) long‑term assumptions that reflect where we expect valuations to ultimately settle. The combination of these inputs – and a view of timelines over which they may converge – allows us to build a full picture of potential future capital market returns. This underpins our entire investment strategy and shapes the expected growth rate (EGR) which we provide for our smoothed funds.
An essential first step is establishing well‑founded priors – grounded expectations for how asset classes tend to behave given the prevailing macro environment, and in relation to one another. Being explicit about the assumptions underpinning our valuation estimates also helps us identify where those estimates, rather than the market itself, may be flawed, and to frame appropriate confidence bands around them. Naturally, such confidence bands are looser over the short term, but narrow over time.
Process to generate a path of expected returns draws on starting valuations and our long-term assumptions
How PruFund is invested
Much of the record gains in 2025 have been driven largely by an increase in valuations, rather than an improvement in fundamentals. In fixed income, elevated starting yields have combined with a decline in US yields and a further tightening in credit spreads. In equities, global (ex US) markets benefited from a rotation away from US assets, alongside a recovery in price multiples that had compressed somewhat last year.
As a result, our medium-term assumptions have moderated across most public markets. In absolute terms, total yields are not far from our long-term assumptions, allowing us to remain constructive on portfolio returns over these horizons. While volatility is to be expected, its impact can be mitigated through broad diversification across regions and risk factors, and by avoiding concentration and valuation extremes.
In particular, our regional diversification within global equities has been accretive to returns over the past year, and shown a significant differentiation to peers who are on average placing greater reliance on a global market-cap approach that is disproportionately weighted to the US, and missing out the growth in European, Asian and Emerging Market equities. Given this strong performance, we are closely weighing current equity valuations. Whilst on average these markets have become more expensive, it is not as clear cut as credit markets which have been exhibiting signs of valuation extremes, with spreads relative to government bonds at (or near) cycle lows. While such conditions can persist in the near term, history suggests they are typically followed by spread widening and lower excess returns.
In the near term, markets may continue to extend these trends further into 2026. However, over the longer time horizons which guide our strategic allocations, we expect fundamentals to reassert themselves and valuations metrics to matter much more meaningfully.
This content has been prepared by the Life Investment Office (LIO) for information purposes only and does not contain or constitute investment advice.
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