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 we launch 2017, much has changed in the past 12 months. At the outset of 2016, there were many areas of uncertainty and potential threats to fragile US and non-US post-2008 recoveries. Falling energy prices and a Federal Reserve intent on normalizing interest rate policy were major threats. Uncertainties associated with geopolitics, global terrorism, an upcoming Brexit vote and the US election hung over the heads of investors.
Dominating the news in 2016 were angry UK and US voters who defied the expectations of pollsters, markets and other observers. UK voters voted to leave the EU and US voters elected a complete outsider as President. What is behind this shift? We believe it’s the economy.
Post-2008 recoveries in Europe and the US have been subpar by most measures. Well-intentioned regulations, across major industries, have had the unintended effect of discouraging risk-taking, business investment and hiring. This has limited opportunity for businesses and for workers, compared with past recoveries. Political focus on avoiding another banking crisis has produced bank regulation that has reduced lending to all but the most credit worthy. Central banks have tried to replace lost bank lending with “quantitative easing” programs designed to keep market interest rates low. However, only the most credit worthy and those able to issue publicly traded debt could borrow money at these low rates.
While the wealthy had means and government programs continued to provide resources to poor and immigrant communities, the working middle class felt they had been left behind. Their job opportunities have been limited, they do not qualify for government aid and they have little access to credit. Home ownership rates have fallen and rents have skyrocketed. In the UK and the US, this group of voters voiced their discontent through the 2016 elections.
In the UK, angry voters rejected the status quo and chose anything but the EU. The path for exiting the EU is not clear but voters still prefer it to the status quo. In the US, angry voters rejected the status quo and chose something completely different. The “populist” appeal of pro-business, pro-growth, pro-domestic worker policies had been greatly underestimated.
Strong post-election equity market rallies in the UK and US suggest investors are bullish on growth. The change in priorities away from risk aversion and “playing not to lose”, towards encouraging risk-taking and “playing to win”, has the potential to lift the trajectory of an economy and improve returns for equity holders.
The hope is that, by example, the US administration’s growth focus will lead the rest of the world. It is possible that a pro-growth competition can be created across economies and trading partners. Which country can create the most attractive pro-business environment? Which country can streamline regulations to those necessary to meet environmental and consumer protection while encouraging business formation? This kind of competition could lead to many locally-based, pro-growth policies around the world – policies that benefit companies, workers and shareholders. This is the potential for investors as 2017 unfolds.
Valuation analysis is how we know what offers the most value for investors. In the equity markets of Europe and Japan, expectations are rock bottom. But, in these” low-expectation” markets, small improvements in growth and the adoption of growth policies could produce significant movements in market prices. As global investors, this is where we find the greatest opportunities. As the chart above indicates, Large Companies in developed Non-US markets (ie, Japan, France, Belgium, Austria) are most attractive, followed by Small Companies in the same markets. And both are more attractive than Emerging Markets.
It is not enough to know which company or group of companies will out-earn the rest. Investors must compare this against what is reflected in current market pricing. Example: US companies may grow earnings at twice the rate of their European counterparts in 2017, but if they are selling at a price that reflects four times the rate, then an investor is better off buying the slower growing, cheaper European companies – and waiting for market prices to adjust.
As for the bond market, where are the opportunities? Around the world, pro-growth policies will result in High yield and Corporate Bonds being more attractive than similar maturity Treasury Bonds. However, in the near term, the single biggest driver of fixed income returns will be higher interest rates. What factors will drive this and what should bond investors be watching? They should watch what central banks are carefully watching: bank lending, growth and inflation. Upward shocks in growth or inflation indicators are the main risks to bond investors, near term. Short Term Corporate bonds provide investors with the most protection in such scenarios. Holders of long-term bonds are the most vulnerable. A potential rapid rise in interest rates in major economies also presents significant risk to Emerging Market Bonds and Equities – as capital leaves those economies.