So where are the investment opportunities early in 2014? For us at The Headlands Group, this means “What are the undervalued markets and asset classes?” When markets and asset classes are priced below value, they offer investors the best potential future return. Among equity markets, the most attractive individual markets are in Europe and Japan and the least attractive market is the US. Globally, Small Companies are generally less attractive than Large Companies. As a group, Emerging Market Equities offer increasingly attractive valuations but carry near term risk. Among bond market sectors, all are overpriced. Relatively attractive ones include 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 – Defining the path to unwinding record stimulus
Early in 2014, major central banks are defining the path to unwinding unprecedented stimulus programs. The danger to economies is that if these programs are in place too long, beyond what economies need, they can cause high inflation. As central banks seek to interpret economic signals, deflation continues to be a bigger concern than inflation. Central banks need to assess if they have done enough to make capital available while maintaining the fortification/stability of financial institutions. They need to determine the impact the unwinding will have on bank stability, capital markets and the pace of recovery. The main concern for investors is that a faster pace of recovery could cause central banks to act sooner and more aggressively.
Bond Risk Today – Heads up!
What is the primary risk for bond investors? It is that the forces that have produced unprecedented capital gains for bond holders, and kept bond yields low, will reverse and produce capital losses. Investors got a taste for what could happen when unwinding talk pushed rates up sharply in the spring of 2013. Stronger economic growth will result in less and less involvement by central banks in government bond markets. As central bank influence is wound down, bond yields will reflect economic fundamentals and be set by market forces. Stronger growth will also mean an end to near zero short term rates. As a result, all bond yields will rise and bond investors will have losses.
Bonds – All are overvalued and vulnerable
Since all bonds of higher credit risk are priced as spreads over government bond yields, low government bond yields hold down the yields of all other bonds. To varying degrees, this has meant that all classes of bonds are overvalued. Long-term bonds are more overvalued than short-term ones and government bonds more overvalued than corporate bonds. Our valuation work finds Intermediate/Short-term Investment Grade Bonds and High Yield Bonds most attractive. Non-US Developed Market Bonds also offer value, as beaten down non-US currencies offer recovery opportunities. Least attractive are all maturities of US Treasuries and Emerging Market Bonds, where strong investor demand has pushed yields very low.
Equities – Continue to benefit from easy money and low rates
In a low interest rate environment with easy money, equity investors will pay more for a given amount of earnings. As long as interest rates remain below the levels consistent with economic fundamentals, they will pressure equity valuations higher. Rates are so low today that even at 1% higher levels they would still be too low. Thus even when rates start to rise, equity investors have a ways to go before their tailwind becomes a headwind.
Emerging Markets – Is it different this time?
If major central banks were forced to raise rates more aggressively, this could be a shock to emerging markets. The key questions for investors are: Are the days of capital controls, currency devaluations and dollar debt defaults behind them? How would their financial systems respond to potential capital flight, falling currencies, and bond losses reducing reserves? Following the global credit crisis that left them relatively unaffected, emerging markets have been the beneficiaries of significant capital inflows. Excesses/bubbles potentially exist today in their markets and economies. Today’s emerging markets, however, have access to healthy local currency debt markets, use floating exchange rates, raise rates to defend currencies, are politically more stable and provide better data transparency.
Equity Opportunities – Which markets?
Our valuation work across equity markets finds the most attractive valuations in European markets and in Japan. Within Europe, small peripheral markets such as Spain, Italy, Austria and Belgium are more attractive than large core ones such as Switzerland, Netherlands and Germany. The UK and Japan also continue to offer attractive values. The US market, the largest and safest in the world, is the least attractive, having benefitted greatly during the nervous recovery of the last few years. With the exception of Pacific markets outside Japan, Small Companies in all markets continue to outperform their larger counterparts and as a result are relatively overvalued. Emerging Markets as a group are undervalued, but carry special risks associated with the expected unwinding of major central bank stimulus programs.