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.
Negotiations between the Greeks and the Eurozone reached a new level of brinksmanship recently. The lesson from Lehman Brothers failure in 2008 was that if a failure can’t be done safely, all of its impacts are known and manageable, it is less costly to try to prevent it. How many entities were doing business with Lehman? No one really knew until after its failure.
Comments from central bankers in recent months were that a Greek exit from the Eurozone was an unknown and unmanageable event. The threat of Greece leaving the Eurozone has been around now since 2010. The European banking crisis was transformed into the sovereign debt crises as bank debt was transferred to government books – then later to ECB books. Perhaps now the Eurozone believes it is safe and less costly to allow Greece to leave the Eurozone – that its impacts on the European and world financial system and economy are known and manageable.
As anyone who looks at a chart of US government revenues and expenditures, as a percentage of GDP, knows, budget deficits fall and fiscal health improves when the economy is growing and tax revenues are growing with it. Historically, a growing economy has been more successful at delivering fiscal health than government austerity.
Meanwhile, China has taken significant steps to try to stem the recent collapse of its equity market. Market prices of A shares in particular had rallied strongly over the past year on market liberalization steps, as well as speculation of the A shares being added to emerging market indices. This was happening even as growth was slowing and capital inflows were reversing. The recent market correction towards levels more consistent with fundamentals has been a source of discomfort for the government – and the battle to stem the carnage continues.
Recent developments in Greece and China argue for longer and more coordinated global central bank synchronization and support. The relative prospects for near term valuation opportunities continue to evolve. Japan stands alone in terms of being the most solid valuation opportunity, as Europe’s market and economic recoveries deal with the uncertainty of Greece. Further declines in July of undervalued European markets offer even more opportunities for those willing to weather the Greek storm. Budding recoveries in both Japan and Europe have been gaining traction and local central banks are aggressively supporting growth. As they recover, demand for their assets and currencies should follow.
Russia and Brazil remain more risky valuation opportunities, given slowing growth and increasing capital outflows, particularly with China drama hurting all emerging markets from a risk aversion perspective.
On the relatively 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 and Korea equity overvaluations are still supported by globally easy money, but are more vulnerable due to a China-related accident associated with regional capital flight and slowing growth. Emerging market bonds face the same near-term accident risk.