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.
Equity market volatility jumped recently from below normal to above normal – volatility not seen since the 2012 sovereign debt crises. Is it the uncertainty of Fed policy? Is it the prospect of China’s slowing impacting the US economy? Fed Board members have been talking about monetary policy being “data driven” and trying to prepare markets for their first quarter point increase…October/December? A reading of the Fed meeting minutes of the last year suggests that the Fed is not just watching traditional US economic and inflation indicators, but also paying attention to financial market stability and developments in non-US economies. In seeking to minimize market instability by communicating their intention to raise rates, ironically, they are actually scaring market participants and creating more instability. Why? A single rate hike, no matter how small or how few, signals the start of a tightening cycle.
Looking around the world, we have capital flowing out of emerging market economies at its fastest pace since 2008 – weakening EM currencies and markets. Fledgling recoveries are struggling to gain upward momentum in Europe and Japan. Central banks around the world are providing significant liquidity to soften landings/establish recoveries. At the start of 2015, the World Bank identified the single biggest threat to global growth for the year as the Fed starting a tightening cycle – effectively squeezing world liquidity, not just US liquidity. Furthermore can the US’s credit challenged, employment challenged, lackluster recovery withstand a tightening cycle? Market participants do not think so – and the Fed will listen. We can therefore expect more of the same from the Fed. A quarter/half point and nothing after is possible and still benign from a liquidity perspective, but it’s hard for the Fed to get there and still avoid the signaling problem.
What are valuations measures telling us at quarter-end? Developed global equity markets: Across the board all valuations have improved with the recent sell-off. Japan and peripheral Europe continue to look most attractive while the US and Pacific ex Japan the least attractive. Note that the recent sell-off has hit Pacific ex Japan hardest and moved them closer to attractive European markets. The expectation is that relative outperformance in Europe will cause us to slowly rotate out of those markets and into Pacific ex Japan. With the exception of Pacific ex Japan, small caps globally offer less value than their large cap counterparts. Emerging equity markets: Russia and Latin American markets are the most attractive while China and Pacific Markets the least. Currencies: The yen, Aussie dollar and Canadian dollar offer the most attractive values while the Swiss Franc is the least attractive against the dollar. The British pound and Euro are close to fair value.
Developed bond markets around the world continue to be excessively priced due to the use of government bonds as monetary policy tools. Credit spreads (high yield and investment grade) have widened out to attractive levels, as they have followed equity market sell-offs. Dollar denominated, EM sovereign debt spreads have not followed high yield spreads. Our understanding is that the existence of local currency denominated EM debt has taken the pressure off these spreads during this cycle. Thus EM spreads remain low and unattractive. Oil is now undervalued, while gold remains significantly overvalued.