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.
As investors start 2016, there are many areas of uncertainty in the near term outlook: geopolitical, terrorism, energy prices, US election, US monetary policy, emerging markets, China, recoveries in Europe and Japan. In markets, we have rising credit defaults, widening credit spreads, rising US interest rates and volatile equity markets.
The US domestic focus in recent years has created power vacuums around the world. Aggressive regional players such as Russia, Iran, China, North Korea have grown bolder as a result, and represent an ongoing source of uncertainty. The next major Jihadi terrorist attack continues to hang over the heads of Western societies. Collapsing energy prices in 2015 have so far been an indication of excess supply and more notably weakness in demand. The focus has been on energy producers such as Russia, Saudi Arabia and US shale oil companies: where economies, earnings, equity prices and credit spreads have all suffered. What has gotten very little discussion/press, except maybe from the Federal Reserve, has been the positive impact on users of energy. The Fed has made statements about lower energy prices temporarily keeping inflation indicators lower and lower oil prices being a net positive on the US economy (a net user of energy). However, investors are still waiting to see significant positive incremental effects on US economic and earnings growth.
The US presidential election promises to be a major source of uncertainty, as it remains to be seen if a disgruntled US electorate is willing to vote in a complete outsider as president. The Fed has symbolically begun its “tightening cycle” with a 25 basis point rate hike in mid-December. Since the Great Recession, the US and other major world central banks continue to pursue unprecedented expansionary monetary policies (using entire yield curves) to support borrowing in the absence of normally functioning banking systems. The persistence of these policies has crowded out savers and bond investors alike, and prompted many to rethink long-term interest rate assumptions. One question is whether the Fed can stick to its “tightening” plans despite market volatility and uncertain non-US economic developments. Emerging markets and in particular Russia, Brazil and China are showing signs of many years of excess capacity and over-investment. As capital flows out and local business activities are forced to shrink, they remain a source of potential economic accident risk. Managed economies don’t shrink as gracefully as unmanaged ones, nor as transparently. Economic recoveries in Europe and Japan are struggling to establish themselves in the face of the Fed tightening global credit conditions and the potential unknown contagion effects from shrinking emerging market economies. The ECB and BOJ continue to provide aggressive monetary support, but recognize their limitations and the obstacles in the way.
Where are the valuation opportunities and which are most likely to benefit investors in the near term?
Careful readers of this month’s “Valuations Returns” chart will notice that all long-term return estimates are lower than in the past by 100 basis points. This is due to The Headlands Group officially reducing its estimate of the neutral real risk free rate (real return over cash over a full market cycle) from 200 basis points down to 100 basis points. Central banks determine this rate for investors’ home currencies. The prevailing approach taken by today’s central bank’s around the world reflects the “Taylor Rule”, which essentially targets 200 basis points above inflation as neutral policy – and prescribes higher and lower as respectively tight and loose around neutral. The persistence of the post 2008 Fed policy and its recent comments as to where they believe neutral to be today suggest that 200 basis points may be the upper end of this particular monetary policy cycle rather than the neutral point.
Non-US equities, particularly Japan and peripheral developed equity markets in Europe, offer the greatest valuation potential – still recovering from their 2008 troughs. With local central banks focused on full support and avoiding systemic risks, this seems to be the most reliable area – notwithstanding external or emerging market shocks to the system. High yield bonds have moved to the next best asset class opportunity due to two developments since last month: 1) Spreads have risen as the Fed raised rates and defaults rose for primarily energy/commodity related companies and 2) The neutral yield has fallen as the real risk free rate estimate has dropped. Note that this second point has made all bond assets more attractive than before. If 500 basis points over Treasury yields is neutral for high yield, then the current spread of nearly 700 basis points over should be considered attractive. This is particularly true if the Fed is correct about strengthening US growth and other major central banks are successful at establishing economic recoveries. Non-US small cap stocks, particularly in Pacific developed markets, offer the next best valuation opportunities. They have generally done better than their large cap counterparts due to lower export and EM exposures. Emerging markets are neutrally priced as a group despite having very cheap markets such as Brazil and Russia on one end and expensive ones such as China and Indonesia on the other end.
Bond asset classes continue to be overpriced as a group due to major central bank crowding effects and banks needing safe holdings to meet capital requirements. There is no end to either source of bond demand in the near term outlook, so that these overvaluations are likely to persist. Note that within these asset classes, credit is increasingly more attractively priced as are certain non-US currencies such as the yen, Canadian/Australian dollars, and to a lesser degree the Euro. Finally, safer US equities, particularly small cap, are the least attractively priced. Note that with central banks continuing to pursue aggressive stimulus, all risky assets will be supported. This means that the scenario for investors realizing value from undervalued non-US equities also involves US equities continuing to rise but to a lesser degree.