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.
Since year end, notable changes in relative valuations have come primarily from widening credit spreads. High yield bond spreads over Treasuries, driven by oil industry borrowers, have risen to over 800 bps. High yield spreads average 500 bps and rise to 1000 bps during a typical recession, so 800 bps is about 60% of the way to a recession level. Widening high yield spreads transmit the same signal about the economy as lower equity prices. In the US, we have seen a 15% drop (peak to trough) in equity prices. This is about half way to the 30% drop of a typical recession. Per the Fed, US market turbulence “does not reconcile” with the progress the US economy is actually making. High yield bonds are now the next most attractive asset class after non-US large cap equities. Equity markets in Europe and Japan continue to offer the best valuation opportunities, and local central banks are keeping the wind at the backs of investors.
In January, markets went from concern that the Fed would raise rates too fast to fears of US recession. Falling oil prices continued to pressure the oil industry in the US and around the world. In the US, oil industry troubles triggered the highest bond default rates since 2009, a decline in corporate earnings and a decline in business investment. News on China’s economy, its companies and its corrupt officials continues to point to a long and drawn out slowdown. Japan confirmed its GDP fell in two of the last three quarters. The BOJ has officially taken short rates into negative territory. It still remains to be seen what the spillover effects on the US will be from a weak China, slowing emerging markets, and recessions in Europe and Japan. Some European countries already have negative short rates and negative US short rates have been discussed as a possibility in 2016. Some weaker than expected US monthly economic indicators have also given markets more to worry about.
The most insightful characterization of early 2016 market sentiment is the suggestion that it will take a full generation of investors to stop “flashing back.” The flashback to 2008 is the fear that the oil industry woes, like subprime debt, will take down the whole economy. The flashback to 1997-98 is that today’s emerging market troubles will spread to the developed world. At that time, the Asian and Russian Crises spread to all world markets – just like fears of a repeat are doing today.
The most interesting response to January’s markets came from the Federal Reserve Board, which monitors and reports regularly on non-US economic conditions and overall world market conditions in addition to keeping track of the US economy. The recently released late January meeting minutes had a number of interesting observations. According to the Fed, indicators in December and January suggest that, despite a struggling energy sector, the US economy is on a solid recovery track. The Fed considers widening credit spreads and falling equity markets “difficult to reconcile” with economic developments. Wider credit spreads and lower equity prices effectively tighten liquidity conditions on the US economy – raising the cost of capital for business. The Fed considers this “market tightening” essentially doing the same work as its originally planned rate increases later this year. Therefore, the Fed will put additional rate increases on hold for now – similar to the decision it made at its last September meeting. This is good news for risk-taking investors worldwide.