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.
Despite all the talk of central bank policy dispersion, “US tightening while the rest of the world eases”, the better analogy is that central banks around the world are increasingly aligned. Recent US weakness and early signs of recovery in Europe and Japan remind us that the Fed is very far from a tightening or even a neutral monetary policy, and will likely remain that way for the foreseeable future. The better analogy is a single major world central bank monetary policy for an increasingly interconnected world economy. This policy may be too easy for the US but easy enough to support nascent recoveries in Europe and Japan – and to keep overbuilt/overcapitalized emerging markets from collapsing. The Fed faces little domestic pressure given low money velocity, low inflation pressure and a sub-par recovery. Global accident risk potential remains high from Greece/Europe, Japan and from most of the emerging markets – not to mention from geopolitical uncertainty. The Fed will likely remain near where it is for some time.
With that as a backdrop, not all valuation opportunities are created equal in the near term. Japan and European equities valuation opportunities have the best prospects. They are developed markets. Their local central banks continue to aggressively support growth and their budding recoveries are starting to gain traction. As they recover, demand for their assets and currencies should follow. Russia and Brazil, while beaten down over the past year, remain more risky valuation opportunities, given slowing growth and increasing capital outflows.
On the overvalued side, US monetary policy continues to support US equities, as does an established recovery, and also to support US bonds. Rather than a collapse anytime soon, the more likely scenario is less upside potential, due to pricing, compared with better priced non-US markets. High and low quality (high yield) credits in the US are also well supported by the Fed and recovery progress.
China, Malaysia, Korea and Taiwan equity overvaluations are supported by globally easy money, but are more vulnerable due to an accident associated with regional capital flight and slowing growth. Emerging market bonds face the same near-term accident risk.