With the completion of the first half of 2013, where are the investment opportunities? At The Headlands Group, we ask “What are the undervalued markets and asset classes?” Among equity markets, the most attractive individual markets are in Europe and Japan, while the least attractive market is the US. Globally, small companies are generally less attractive than large ones. As a group, emerging market equities offer modest undervaluation. Among bond market sectors, all remain overpriced. Relatively attractive are US short-term and intermediate-term investment grade, US high yield and non-US developed market bonds. Least attractive are all maturities of US Treasuries and emerging market bonds.
Central Banks – Fed signals tapering!
The ECB and BOJ continue to offer aggressive, unprecedented stimulus to their lackluster economies. Recent improvements in housing and employment prompted the Fed in June to signal and prepare the markets for an end to its bond purchase program. Halfway through 2013, the flight-to-the-safest-assets theme in global markets is less dominant. Investor fear has gradually fallen away with a shift from Treasuries to investment grade bonds, high yield bonds, emerging market bonds and US equities. Bank capital requirements continue to drive demand for the safest assets. Bank demand for Treasuries is starting to wane, however, as mortgage lending opportunities improve and the Fed plans an end to its Treasury market support. These three major sources of recent demand for Treasuries are thus falling away.
Bond Risk Today – Lookout! – It’s starting to happen
The primary risk for investors is that the forces that had produced unprecedented capital gains for bond holders and supported lower yields will reverse and produce losses. As in the past, indications of a Fed change in monetary policy direction tend to be extrapolated quickly by markets. It is important to keep in mind, however, that monetary policy has a long way to go to even reach neutral. The Fed’s anticipated exit from Treasury bond market support has translated into a major recent jump in Treasury yields. This has had a significant impact on all bonds. Emerging market bonds were especially hard hit, as one of the primary drivers of their recent bull market has been the Fed making Treasury bonds less attractive.
Where are Treasury yields headed? When the Fed steps out of Treasury bond market support, investors can expect yields to move towards levels more consistent with growth and inflation conditions. For the ten-year note, this means its yield should move towards inflation plus a normal spread of three percent – a total yield of five percent for a two percent inflation rate. Stronger than expected growth could potentially push yields even higher. Investors should prepare their bond portfolios for this eventuality as the recovery accelerates.
Bonds – Overvalued but moving towards value
All classes of bonds remain overvalued, to varying degrees. As the US economy recovers and US yields rise, valuation work guides bond portfolio positioning. Long-term bonds are more overvalued than short-term ones and government bonds more overvalued than credit bonds. When yields rise, shorter term bonds will outperform longer term ones. Investment grade and high yield credit spreads cushion against rising yields, and also tighten as the economy improves. With beaten down currencies, weaker economies and accommodative central banks, non-US investment grade bonds offer relative opportunities. Least attractively priced are emerging market bonds. Their spreads relative to Treasuries are not compensating investors for the risk, particularly for those denominated in local currencies.
Equities – Shifting the focus to growth
US equity prices have now caught up with the earnings recovery and PE ratios are above historical norms. In a low interest rate environment, equity investors typically pay the highest prices for a given amount of earnings. Outside the US, equity prices in major developed markets continue to lag earnings growth and remain below their pre-credit crisis highs. While the recovery will pressure bond investments, improved investor risk appetite and the focus on earnings should benefit equities. The factors that had driven the recovery in equity prices – Fed stimulus and lower bond yields – are ending because the economic outlook has improved. Equity investors, as direct participants, will be the beneficiaries of this improvement. The growth focus has already started to happen. When the Fed announced in June that it would taper its bond buying, equity markets reacted negatively. They subsequently rebounded as investor focus shifted to stronger growth and earnings.
Equity Opportunities – Which markets?
Caution and low risk remain the dominant pricing themes across global equity markets. Lowest risk US has made the most progress recovering from its 2009 bottom, and now surpasses its pre-decline peak. Our valuation work across markets finds the most attractive valuations in Europe and in Japan. Recent excitement about stimulus measures in Japan has pushed that market higher in 2013, but it is still well short of its late 2007 peak. Investors remain unconvinced that it is safe to buy troubled European markets. Within Europe, small peripheral markets such as Spain, Italy, Austria and Belgium are more attractively priced than large core ones such as Switzerland, Netherlands and Germany. The UK also continues to offer good value. The US market, the largest and safest in the world, is the least attractive. With the exception of Pacific markets outside Japan, small companies globally have recently outperformed their larger counterparts and as a result are relatively less attractive. As a group, emerging markets have fallen modestly below value this year, as political risk and capital flight have become concerns.
