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.
The Election – A game changer for the markets?
The US equity market completed a lackluster and weak October before the election, unable to rise above post-Brexit highs reached early in the third quarter. The uncertainty of a close race caused market weakness and investor hesitation. Mrs. Clinton was expected to be elected president, with a high probability, and markets planned for more of the same. As the election neared, the conventional wisdom was that an unlikely Mr. Trump win would result in a 10-15% drop in the market. Electing a non-politician with a volatile temperament and unclear policies would be very concerning to investors. As Election Day unfolded, electoral votes were tallied and Mr. Trump’s chances of winning grew. Overnight futures markets indicated US equities would be down 800 Dow points or about 4%. Late into the evening, when enough electoral votes had been counted, Mr. Trump was declared the winner and Mrs. Clinton conceded the election. Mr. Trump then gave a very inclusive acceptance speech, reaching out to supporters and non-supporters alike and stressing national unity. The speech calmed investors and equities reversed course. The overnight selloff disappeared and by Wednesday’s opening bell, the equity market was moving higher.
By the end of November, large and mid-cap stocks had finished the month about 4% higher and small cap stocks about 9% higher. Since then, US equities have set new record highs. Bonds fell dramatically as yields rose to levels not seen since mid-2015, when the Fed was expected to raise rates several times. All income producing investments were hurt, as it became a certainty that the Fed would raise interest rates in December. In anticipation of higher US rates and uncertain trade policy, the dollar rose strongly. Furthermore, potential US protectionist policies towards China, Mexico and other emerging markets, sent their equity markets, bonds and currencies tumbling. Non-US bonds followed US bonds lower, as they often do during major moves. Higher bond yields in Europe and Japan effectively tighten monetary conditions and work against their central banks’ loose monetary policies. As the new administration potentially over-stimulates a mature US economy, there are also investor concerns about inflation heating up.
The Outlook for Markets and Valuation – What can investors expect?
Potentially improving US growth, rising short term/long-term rates, first in the US and then outside the US, will set the tone for what happens to all financial markets. In bond markets, short term should outperform long-term. Credit spreads should come down as economic growth improves, helping corporate bonds over government bonds. This should be true for high yield too. Equities, like other investments, such as housing, will be helped more from the better growth outlook than hurt from rising rates. The tailwind all risky assets have enjoyed from easy money/low rates will start to dissipate. It will become a headwind. As markets enter a more typical second stage of a market/economic recovery cycle, GDP and earnings growth will take over support of risky assets. We continue to monitor undervalued non-US equity markets for signs of new fiscal policy stimulus, such as what we expect in the US, rather than more monetary stimulus. This will allow markets to reward patient investors who have been willing to buy their undervalued shares. As this happens, non-US currencies should recover along with non-US equity markets.