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.
Emerging market equities have been moving to the overvalued side of the chart – driven by an increasingly overvalued China. With credit spreads near historical lows for emerging market bonds and high yield spreads heading there fast, the move in emerging market equities appears to be related. Historically, capital flows from developed markets have been major drivers of rallies and sell-offs in emerging markets. These are typically investor risk appetite-based and tied to Fed policy. The Fed’s “no rush” approach to raising interest rates seems to have pushed up risk appetites and consequently valuations for these markets.
The conversation at the Fed about the normalization of policy is potentially a catalyst for the correction of many overvaluations. With all bond asset classes overvalued, investors need to take a close look at not only their bond portfolios, but all of their income-based investments. Investments like residential real estate have benefited from abnormally high rents, due to the difficulty many would-be buyers have getting mortgages. Demand for income has driven residential real estate prices up and their yields down. With bank deregulation underway and interest rates rising, these investments could get hit from both sides: a drop in rental demand and a drop in demand for income investments. Key questions today for all income-based investments are: Do current valuations compensate for the risks? Is there enough participation in growth to offset the impact of higher interest rates?
Normalization plans and monetary policy
By all measures, US monetary policy remains at unprecedented levels of accommodation. The plan is for the Fed to gradually reduce accommodation and allow interest rates to rise. Weak growth, disinflation, and an over-regulated financial system warranted the unprecedented accommodation. As these conditions dissipate, growth picks up, inflation returns and de-regulation occurs, there is less need for the Fed’s “emergency monetary policy.”
Disruptions to the Fed’s plan to be gradual can come from higher than expected growth or inflation, and even from faster than expected bank de-regulation. Such “positive surprises” would likely cause the Fed to act faster and be very negative for investors. This is the major risk investors face today – the potential catalyst that threatens their overvalued asset class holdings.
All financial assets are impacted by the level of interest rates. Those denominated in US dollars are impacted by the level of US interest rates. Typical bond portfolios have interest rate exposure and credit exposure. Interest rate exposure is straightforward. When interest rates rise, the prices of longer duration bonds decline more than those of shorter duration bonds. Financial assets such as equities have a growth component. If faster growth is part of the reason that rates rise, then growth-participation assets are less vulnerable. Growth can also support tight credit spreads. However, starting at today’s very tight credit spreads means little compensation for risk and does not leave much room for spreads to tighten further. A sudden significant jump in interest rates can potentially slow growth and cause a recession. This would hurt equity investors and widen credit spreads, creating big losses for high risk bond investors.
That being said, where are the valuation opportunities? How does a valuation investor want to be positioned? On the equity side, non-US large cap markets continue to offer the best values. Lackluster post- 2008 recoveries in Europe and Japan mean central bank support there continues. Investor pessimism over the years has pushed valuations down. Recent growth indicators in Europe and Japan have been better than expected. The combination of all three has pushed their equity markets higher in 2017, although many remain significantly undervalued. The recent rebound in China and other emerging market equities, has pushed emerging market equities from near value to significantly overvalued. Likely this has been due to investor complacency about the pace of Fed action. This same complacency continues to keep long term Treasury bond yields low.
All bond asset classes remain significantly overvalued, an unprecedented generational-sized bubble. This bubble threatens not just US dollar-denominated bonds, but all financial assets that derive their return from income and do not participate in growth. US equities, small and large cap, remain at the overvalued end of the chart. They are vulnerable to rising interest rates. However, equities participate in growth and thus, to the extent rising rates are accompanied by faster than expected growth, this will limit their vulnerability – especially if monetary policy remains in an accommodative range.
Valuation-based global equity portfolios remain overweight Japan and certain European markets at the expense of US, Pacific ex-Japan markets and other European markets. Valuation-based bond portfolios are dominated by overweights in short term investment grade bonds and developed non-US bonds at the expense of all Treasuries, intermediate/long-term investment grade bonds, high yield and emerging market bonds.