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.
After starting the year with equity markets headed straight down and talk of US recession and a repeat of 2008, sentiment reversed course in mid-February and through March. Successive Fed spokespeople have voiced concern about the potential impact on the US economy of market volatility and uncertainty stemming from the weakness in non-US economies. This concern has translated into communications that the originally planned increases in short term rates in 2016 are likely to be fewer than expected, and the pace of normalization more gradual. Equity markets, high yield bonds and oil prices have recovered from their recent lows.
The market response to the Fed has once again elicited commonly heard words from market observers such as “bubble” and “Fed driven market”. Economic data since December continues to indicate normal monthly volatility in the US economy’s subpar recovery. In response to the comments, it is probably worthwhile to make a few comments about the special relationship in this recovery between Fed policy and growth. Why is the Fed at a zero/near zero interest rate policy and why does it remain appropriate? The answer lies in understanding the Fed’s desire to make credit available to the economy while ensuring that the banking industry does not fail. Ensuring that banks don’t fail means a tight regulatory structure that discourages risk taking/lending. This means many borrowers must resort to alternate, non-bank lending sources such as capital markets and peer-to-peer lenders. This has meant keeping the entire yield curve low so that the cost of debt capital, globally set relative to the US government yield curve, is as low as possible. Furthermore, the price of equity capital to the economy, set through stock prices, is also being kept low (high P/Es) to make equity capital cheap to raise for companies. So markets are really functioning as very important monetary policy tools for central banks today.
Fears earlier in the year were not just about monetary policy reversing, but rather that a lethargic US economy would not be able to maintain its growth in the face of a central bank that thinks it is growing too fast and is ready to reduce liquidity. Furthermore the Fed’s liquidity is increasingly global and threatens slowing emerging markets and very weak recoveries in Europe and Japan. This threat has largely dissipated as we begin April. Markets are back to being concerned about: US earnings slowing, the US presidential election, the UK’s potential European Union exit, terrorist threats, Europe and Japan recoveries, slowing growth in China and other emerging markets. Risky markets are thus once again resuming their “wall of worry” climb.
Against that backdrop, credit spreads have come down from their recent highs, but remain attractive compared to historical norms. Relative attractiveness of equity markets continues to favor lagging developed non-US markets in Japan and Europe. Small companies have held up better than large companies, likely due to greater exposure to strengthening local economies and less to weaker export markets. As a result, they are less overvalued than non-US large companies. These are really the three best opportunities globally for investors today. At the other end of the spectrum, top performing and overvalued US large and small companies are least attractive from a valuation perspective. All risky assets, however, continue to have the central bank winds at their backs, as they are effectively being used as monetary policy tools to make equity and debt capital available to issuers in the economy.