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.
Evidence of improving growth continues to mount in major economies around the world. The sustainability of the growth has prompted major central banks to increasingly discuss and make plans to slowly bring an end to historic levels of quantitative easing (QE). The future of QE has a significant impact on investors and particularly those relying on the stability of income-oriented investments in their portfolios. What should investors look for that would accelerate the ending of QE among major central banks? Growth and or inflation indicators rising faster than expected will indicate to central banks that they are behind the curve and prompt them to act faster. The other parameter that must be watched by investors is bank regulation reform and streamlining. To the extent the pace of bank regulation reform, an area of priority for expected new Fed Chairman Powell, picks up, this will have the same effect. The initial focus of the bank regulation reform will be easing requirements on smaller banks that present less systemic risk.
A student of the history of quantitative easing programs will note that they are designed to use the entire yield curve to provide capital to the economy. Unlike traditional easy money policy, which reduces short rates temporarily to stimulate the economy during recessions, QE programs follow major collapses in the financial system that are accompanied by “shut-down” regulations designed to prevent another collapse. Such programs can go on for many years and are arguably needed to replace non-functioning financial systems. The world saw this for the first time in the modern banking era in Japan, following the collapse of their 1980s boom period. To this day, Japan continues with its QE program. QE programs were instituted following the 2008 collapse in major developed economies to provide capital to economies that were forced to shut down many traditional bank landing channels. To the extent banking systems are reformed regulatorily and allowed to slowly resume some pre-crisis lending activities, this will reduce the need for QE programs. This is more of a structural than cyclical argument, however, but it should be watched carefully by investors.
Against this backdrop, markets continue to respond in 2017 to the combination of improving growth and supportive monetary policy. Equity markets have rallied strongly and credit spreads have narrowed. Long -term interest rates have not risen in a major way yet, despite indications of the planned reduction in central bank buying and potentially falling demand from capital-focused banks and risk-averse investors. Rising interest rates threaten all investors, but particularly those which are income-focused with limited equity upside participation. We have seen a number of effects on asset class valuations as the year has progressed. Credit spreads, particularly in the lower quality high yield and emerging market bonds, have narrowed closer to past credit peak levels. This indicates that we remain much closer to the peak in the credit cycle than the trough. Another indicator of this is that the search for yield has moved beyond publicly traded low quality credit towards less diversified and less regulated private credit areas. Credit cycle peaks are notable for the willingness of investors at the time to accept only marginally higher yields for significantly greater risk. This will not end well for investors when the next recession hits and the credit cycle peak comes to an end.
Emerging market equities have been the strongest performers, as investors shrug off the potential for rapid rate increases in developed markets to produce a flight to quality out of these markets. As a group, their valuations now firmly exceed neutral and the chart shows a clearly negative valuation return. A closer look at these indicates that valuations differ by market, with China at one end significantly overvalued while Russia sits at the other end significantly undervalued. Similarly, developed equity markets feature major overvaluations in US large and small cap on one end and major undervaluations in Non-US large and small cap. Within Non-US developed market equities, Japan and certain peripheral markets in Europe offer the best valuation opportunities. These markets in Europe include, Spain, Austria, Belgium and Italy. Note that France and the UK continue to offer excellent value for investors as well. The British pound and yen offer US investors undervalued currency opportunities also at this time.
