Where are the asset class investment opportunities?
The chart illustrates the effect of current valuation on expected return over the next five years. Buying undervalued assets results in positive valuation returns. Buying overvalued assets results in negative valuation returns.
Federal Reserve spokespeople continue to prepare investors around the world for the potential start of the Fed’s tightening cycle, emphasizing the strength of the US recovery in the face of economic weakness outside the US. Unlike past cycles, the trajectory of rate increases will be much lower we are told. They also continue to mention that the “neutral” level of real short rates is lower today than in the past. All that being said, monetary policy will remain at unprecedented levels of accommodation. How can this this be after 7 years of near zero short rates? What does this tell us about the functionality of the US financial system and the health of the US economy?
It tells us that the new US normal may be high capital ratio, “full reserve” banking, rather than traditional fractional reserve banking. Without fractional reserve banking, we can all compete with the banks to make loans. Thus the “Uberization” of the banking system will only increase as the Fed’s priority is creating a “safe” banking system rather than a “functioning” one. Market-rate based lending to only the worthiest of borrowers, and expensive non-bank lending to all others is the new economic financing normal. It is far easier to regulate “safety”/shut-down banking than to actually help bank lending recover ”safely.” So we should expect, weak, uneven growth and limited capital availability for the foreseeable future.
Meanwhile, the ECB continues to look for ways to support European recovery – pointing out that troubles in emerging markets threaten world growth and require more stimulus. The Bank of Japan seems comfortable with its level of stimulus and economic conditions there are improving, enough so that we are seeing forecasts of yen strength due to undervaluation. Emerging markets are slowing from their rapid pace of growth of the past ten years. Capital continues to flee in the face of overcapacity. The start of the Fed’s tightening cycle will only accelerate this and harden their landings – particularly in China. The Chinese government, having recently achieved “reserve currency basket” status from the IMF, continues to look for additional ways to soften its economic landing. With the start of the Fed’s tightening cycle, Yuan devaluation can’t be far behind.
With this as a backdrop, where are the valuation and nearer term investment opportunities? Despite the tightening cycle, US monetary policy has a long way to go before it actually becomes restrictive and creates a headwind for risky assets globally. Therefore globally targeted ultra-loose monetary policy remains in place pressuring all risky asset valuations higher.
Best valuation opportunities across developed markets globally continue to be in equity markets within Europe and Japan. These are also the best places for near term opportunity. Central banks are stimulating excessively and market recoveries should lead economic recoveries, despite the occasional setback. Next most attractive valuations are certain emerging equity markets, Russia and Brazil, where severe recessions have created massive market declines. However, their near term paths to market and economic recovery are less clear. These recoveries are likely further away, worsening first then becoming U-shaped shaped rather than V-shaped. High yield bonds, have reached fair valuation, as credit spreads are above normal (slowdown/mild recession mode). US energy company high yield borrowers’ likelihood of default has increased with collapsed energy prices. The result may just be expensive debt rollover rather than actual defaults, though. A sustainable US recovery and easy money should continue to support all credit investments. Emerging markets, cap-weighted as a group, indicate fair pricing but face the near term headwinds mentioned earlier. Gold, while less overvalued than before, remains overvalued by our measures. Oil investments are now undervalued after collapsing, but face near term sluggish demand and excess supply headwinds.
US Treasuries of all maturities remain grossly overvalued, but, given the near-term contractionary effect of the start of Fed tightening cycle hurting growth and the promised shallow tightening trajectory, are likely not significantly correcting anytime soon. This can be said globally in developed bond markets where recovery/inflation pressure on yields is minimal in the near term. Emerging market bonds, denominated in US dollars, continue to hold up very well despite the troubles experienced by their local currency denominated counterparts. At some point, we expect those sovereign spreads to eventually widen and losses to be taken by investors – as compensation is low and default risk high.
We agree with the analysis that the yen is undervalued and an eventually recovering Japan will carry the yen higher with it. The Euro is now modestly undervalued, as is the Australian and Canadian dollars. The Swiss Franc remains overvalued by our measures. We expect the Euro to eventually recover with the local equity markets and economies. Natural resource driven Australian and Canadian currencies are likely to take longer – given the trajectory of world growth and commodity demand.