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.
With small cap stocks around the world continuing to rally, along with high yield and emerging markets, undervaluation is getting harder to find. There was a time post-2008 where safe, riskless assets were in high demand by fearful investors and banks looking to shore up capital ratios. Thanks to global central bank QE and bank regulation efforts, demand for safe assets continues to be strong. In terms of investor opportunities today, the choices are: overpriced safe assets, overpriced risky assets and some underpriced risky assets. Economies around the world remain lethargic. This means that government stimulus remains a goal. Led by the Federal Reserve, however, existing aggressive monetary stimulus is slowly being replaced by pro-growth deregulation and fiscal stimulus. We expect European Central Bank and the Bank of Japan to follow the Fed’s lead as their QE programs have also had limited success in producing strong recoveries.
What does this mean for investors going forward? Continuing government stimulus will support risky assets, even those that are considered excessively priced. Policy changes, however, pose a threat to safe assets. Unwinding of QE programs means a lower central bank appetites for government securities. Steps towards reduced bank regulation means lower bank appetites for these safe assets. Increased investor optimism means reduced investor demand for safe assets and more support for risky assets.
The best opportunities on the bond side are for short term bonds with credit risk. On the equity side, opportunities remain for purchasing undervalued individual non-US equity markets. Japan, Italy, UK, France, Spain offer undervalued developed market equity opportunities while Russia, Brazil and Mexico offer undervalued emerging market equity opportunities.