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.
Oil prices still pressured lower as the outlook for the demand outlook continues to weaken, but at a slowing rate from the recent panic selling. Valuation work on oil now suggests modest undervaluation. ECB bond buying announcement has pushed bond yields globally lower. Weaker than expected growth indicators around the world suggest the Fed will be more patient than expected before starting its tightening cycle. The appetite for fixed income globally remains strong. Lower interest rates make equities more attractive and bonds less attractive, particularly undervalued equities in Europe and Japan. Previously overvalued major non-US currencies have fallen to undervalued levels against the US dollar. The flattening in the US yield curve has put more pressure on certain overvalued emerging markets in Asia that are particularly vulnerable to the eventual rise in US rates. High yield spreads over Treasury bonds have risen recently so that they are just modestly higher than normal levels. They remain attractive relative to other US fixed income alternatives
Best asset class valuation opportunities are in non-US large cap equities where weak economies and investor pessimism have depressed both equity prices and currencies. Non-US small cap equities are also very attractive, but to a lesser degree as they have held up better than large caps. Emerging market equities are next most attractive at near fair value. Recent investor favorites US small and large cap stocks provide the least attractive valuation opportunities.
Aggressive world central banks continue to support all risky asset globally, while reducing the attractiveness of government bonds. The current extraordinarily appetite for bond investments globally from central banks, banks and investors means that new bond investors today face significant future losses before they can earn normal returns. As all bonds globally are priced relative to government, all bonds are vulnerable. Low and high quality credit spreads enjoy the same central bank support as equities, however. US high yield and investment grade credit spreads are near normal while emerging market spreads remain below normal. Developed market non-US government bonds offer better near term cyclical value and potential currency rebounds.