Summary – Where does an investor want to be?
So where are the investment opportunities? 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.
Markets – What’s happened in 2014?
So far in 2014, bond yields have fallen around the world. Equities have generally moved higher and emerging market equities and bonds are recovering from a rough 2013. For now it seems that geopolitical risk and Fed tapering/tightening/selling bond risk are no longer major concerns.
This is in stark contrast to how we started 2014. The outlook for EM markets/economies was fragile. Fed talk of tapering in the spring of 2013 caused a jump in US bond yields – giving investors a taste of what was to come when the Fed eventually left the bond market. Middle East and Russian unrest threatened global risk takers.
As 2014 has unfolded, however, the US reported a weak first quarter GDP number and Fed Chairwoman Yellen consistently re-assured investors that US monetary policy will be there to support the recovery. The Fed’s plan seems to be to hold on to its very large Treasury bond inventory, even as it potentially raises short rates next year.
Central Banks – Still supporting economies, and markets
Among major economies, the US and UK recoveries seem to be most consistent. Central banks there, while still very supportive, are recognizing and communicating the eventual end to their open ended support. However, recoveries in Eurozone and Japan are struggling and central banks are promising to do whatever it takes to support growth. The ECB and BOJ are likely to purchase more bonds and keep rates lower longer.
The eventual rise in rates, which will hurt bond and equity investors, is likely to happen sooner in the US and UK than in the Eurozone and Japan. Despite the timing differences, easy money/low rates in all developed markets continue to support higher risky asset prices. All four major central banks (US, UK, Eurozone and Japan) have huge balance sheets today relative to the size of their economies. This pressures equity prices higher and bond credit spreads lower worldwide.
Falling growth in China and lackluster activity in Mexico and Brazil typified slowing emerging market economies in the first quarter. The second quarter saw some improvement, with Korea notably growing faster. Central banks in Chile, Mexico and Thailand have cut rates to support growth while central banks in Brazil and India raised rates to address rising inflation.
Bond markets – Where are we and how did we get here?
US Treasury bills, notes and bonds have been significantly overvalued since panic-struck investors sold equities and any form of credit for the safety of Treasuries in late 2008. Yield spreads of high yield bonds over Treasuries reached an unprecedented 21% in early 2009. In 2009, Treasuries moved in the opposite direction of equities as investor sentiment went from “risk on” to “risk off” and back again a few times. This happened until late 2009 when the Fed altered the pattern by buying Treasury bonds through their Quantitative Easing (QE) program – effectively replacing now calmed investors who were returning to equities and selling their Treasuries. The outcome was that bond yields remained low, even while equities and the economy were recovering.
Two more “QE” buying programs by the Fed gets us to today’s yield curve. It is managed and held below a level that is consistent with inflation and growth at this stage in the recovery. As of this writing the US Ten Year Note has a yield of 2.42%. In a 2.5-3% real growth economy with a 2% inflation rate, its yield should be near 5%. Since all US dollar fixed income instruments are priced as spreads against US Treasuries, this overvaluation impacts the valuation of all US dollar fixed income asset classes such as: corporate bonds, high yield, dollar-denominated emerging market bonds.
Corporate/High yield credit spreads over Treasuries peaked in early 2009, at record levels. They have since fallen quite a bit since, as the economy strengthened and risk appetites returned. Credit spreads are currently below normal but not at cyclical lows by our measures – despite absolute yields hitting record lows and issuance quality deteriorating. Government bond yields are very low in the Eurozone and Japan, reflecting weak economies, low inflation and central bank support. This is less the case in the UK. The yen remains undervalued against the dollar while the pound sterling and Euro remain overvalued.
Emerging market bonds have benefitted from greater investor risk appetite and the search for yield. Their yields over Treasuries stand near unprecedented lows. The past several years have witnessed significant issuance in emerging market sovereign local and corporate local bonds – primarily due to US investor appetite. In our view, their current spreads above Treasuries do not compensate investors for their inherent risk, particularly at this stage in their credit cycle. This is true for the sovereign risk in dollar denominated issues, but even more true for the added currency and credit risks of the local bonds.
Equity Markets – Where are we and how did we get here?
After falling precipitously in 2008, all world equity markets were undervalued. Scared investors fled equities, leaving prices well below values. Since bottoming in early 2009, US large and small companies have lead the recovery in world equity markets. The Fed’s early and persistent support, a solid recovery in corporate earnings and increased investor risk appetite gave them an advantage. Both US large and small companies have set price records, above their pre-2008 highs. Note that earnings reached record levels ahead of prices in this cycle as risk appetite recovery trailed earnings recovery.
Japan’s market recovery has been interrupted multiple times by the 2011 nuclear spill and other fits and starts – as well as periodic loss of confidence in the “Abe-nomics” stimulus plan. Recovering European equity markets have struggled to overcome the sovereign debt crisis of a couple of years ago. Concern that the Eurozone single currency structure will not last have also not gone away.
Emerging markets came back strong after the 2008 collapse, due to the fact that they were underpinned by rapidly growing economies that had largely avoided the global debt crisis. Since that time, weaker growth and capital flight concerns from rising rates have weakened markets and currencies.
Consistent with this recovery history, we see markets most undervalued in Japan and the smaller Eurozone markets. Emerging markets as a group are neutrally valued and US small and large companies are most overvalued.
Outlook: What do we see ahead?
Notwithstanding normal corrections along the way, generous monetary policies/low interest rates around the world can support higher risky asset prices. Using the simple Greenspan model, for example, of comparing S&P 500 earnings yield with the 10 year US Treasury Note yield means a yield of 2.42% is consistent with a P/E of 41. Today’s P/E is than 20. While we are not predicting a 41 market P/E, the pressure on equity prices remains upward.
The main risks investors face are the ending of generous monetary support and the return of interest rates to levels more consistent with growth and inflation. To the extent that recoveries in the US and UK, which are strongest, begin to heat up, central banks may be forced to end support sooner that they or investors expect. Despite reassurances, faster growth and the threat of higher inflation will prompt central banks to act. Investors should expect this and should anticipate higher short and long term rates sooner as a result.
All risky assets are vulnerable. Particularly vulnerable are yield-based investments, which have become very popular in recent years as investors “reached for yield.” The more yield-oriented investments are, the less equity/growth participation they contain and the more they will behave like bonds when interest rates rise. This means in a growth-based/rising rate scenario, yield based investments will be more vulnerable than traditional equities. Investors who have tilted their portfolio towards such income-oriented investments such as REITs, MLPs, preferred stock in recent years need to be particularly cautious, as they have traded off growth potential to get more yield. Traditional equities, even with higher rates, can continue to be supported by growing earnings. This is typically the second phase of an equity bull market. The first phase of a bull market is recession/slow growth/low rates. Due to the unusual circumstances associated with this recovery, the first phase has been extended well beyond its typical length.
Note that emerging markets equities and bonds remain particularly vulnerable to capital flight as monetary policies normalize and rates rise. There are also plenty of sources of geopolitical risk out there that threaten to reverse sentiment on risk takers. The escalation of any one of them could precipitate a major market correction.
