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.
Markets were fairly quiet in August, following some “post-Brexit vote” excitement in July. As discussed in the last comments, Brexit turned out to be more about greater global central bank support for economies and markets than about the more direct, complex and uncertain Brexit vote implications. In this era of ongoing, unprecedented central bank support, reflected in near zero and negative interest rates, economies and market have never been more focused and dependent on this support.
By way of history, the term “quantitative easing” became widely used by investors in describing the actions of the Bank of Japan in the years following Japan’s late 1980s market and economic collapse. At that time the nation’s banking system was saddled with non-performing loans, unable to carry out normal lending activities and forced to own government bonds for capital requirements. Japanese banks effectively became utilities, unable to significantly participate in economic growth by making credit available to borrowers as they had in the past. The Bank of Japan attempted to replace this contraction in available bank credit through monetary policy, by maintaining very low interest rates. The Bank of Japan did this through “printing money” or “quantitative easing”. Bank capital requirements and fearful investors helped keep demand for government bonds high and rates low. Terms like “pushing on a string” were used to describe the policy’s limited effectiveness in reviving growth as the economy experienced periodic bouts of deflation. Arguably, Japan continues to struggle today to sustain a healthy rate of economic growth.
Fast forward to today’s post 2008 Credit Crisis world economy, and things look very similar. Quantitative easing is now being practiced by the ECM (European Central Bank) and the US Federal Reserve Bank. This kind of monetary policy has been going on for so long that it has become the “new normal.” The Fed uses the term “normalization” when describing the process of allowing interest rates to rise back up to levels consistent with economic growth and inflation. In the past, interest rates and the Fed monetary cycle led the economic cycle. With labor market conditions tightening, however, and given the current length of this cycle, it appears as if we are late in the economic cycle and ready to have at least a soft landing without any normalization of interest rates or much inflation build up. The Fed has said that the “new neutral” for real short term rates is zero and Fed Board members are already discussing further stimulus in the event of a slowdown. This means that “normalization” of interest rates will be a structural shift rather than a cyclical one. Bank regulators in the US, Europe and Japan continue to focus on forcing banks to operate as utilities to minimize their risk of failure. They are not focused on getting the banks to resume past levels of lending (risk taking) to make credit available to the economy. Until regulators get banks on the path to “normalize” lending, monetary policy cannot normalize.
Implications for market valuations
Government bond yields are reflected in the yields of all debt securities around the world. Thus artificially low government bond yields keep all yields low. The yield on a bond normally covers inflation in the issuing currency, a real risk free rate (for deferring consumption) and a risk premium reflecting the credit (default) risk of the borrowers. If government bond yields do not compensate for inflation and the time value of money, then investors have to rely on more credit risk to earn a return. This has the effect of making bonds’ expected returns less reliable. It also has the effect of pushing investors in search of income into riskier bonds. Furthermore, the likelihood of sustaining a major loss when interest rates rise hangs over investors’ heads.
An additional implication today is that investors are being offered less reliable investment substitutes to replace the lost potential income and expected return from their bonds. The thoughtful investor will be wise to remember that the first role of bonds in a multi-asset portfolio is to function as risk-free securities with a maturity matching the investor’s time horizon. The bonds should cushion the impact of higher risk equities. Bond contribution to return and/or portfolio income is secondary. Higher risk bonds and less reliable substitutes do not provide the same risk-free cushioning benefit of high quality bonds.
Every financial asset, which derives its value from future expected cash flows, will have that value also affected by the future cost of money. Interest rates therefore price all financial assets and low interest rates push up their values. When we hear market analysts say that equity market valuations are high and therefore expected future returns are low, they are referring primarily to the US equity market and the impact very low interest rates and the economic recovery has had on US equity prices. Despite similarly low interest rates/monetary policies in Europe and Japan, equity valuations there have not followed the US higher. This is due to the more uncertain outlook for their economic and earnings recoveries. Thus the best investment valuation opportunities today come from developed market non-US equities, where recovery pessimism has pushed prices down while interest rates remain low and central banks have pledged to remain supportive for the foreseeable future.