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.
As 2016 unfolded, markets anticipated with some uncertainty these five events: the Fed’s upcoming meetings/policy decisions, the “Brexit” vote on June 23rd, the July party conventions and the November presidential election.
Given the uncertainty in markets associated with the remaining four events, the Fed in June decided that it would not raise rates. Going into the vote, the Fed’s caution and the “Remain”-leaning polls buoyed risky markets. As votes being counted indicated that the vote was moving in favor of “Leave”, markets reversed course. When all votes were counted, voters had decided 52/48 that the UK, the 5th largest world economy making up about 17% of the EU’s total economy, should leave the EU. The UK has been part of the EU for 43 years. Markets sold off significantly the following two days, anticipating the economic disruption this could cause European and world economies.
In an effort to calm markets, alert central bankers around the world reassured investors they would provide plenty of liquidity to ease the impact of the expected disruption. Investors began 2016 expecting the Fed to raise short rates four times, and the Fed’s actions were arguably the greatest source of uncertainty. The removal of this uncertainty through the rest of 2016 was therefore very welcome news. It was so welcome that risky markets promptly reversed course, with many including the UK, reaching pre-vote levels before month end.
It turns out that for nervous investors taking risk in a sluggish world recovery, continued monetary policy support is much more important than the disruption caused by the UK potentially leaving the EU. With each bout of market turmoil, low interest rates and stimulative monetary policies worldwide feel more and more permanent to investors. Economic recovery around the world since 2008 continues to be fragile and subpar- struggling to return to past growth rates.
What is the impact of recent market turmoil on market valuations? Non-UK European equity markets have not recovered and remain significantly lower at month-end. The British Pound is some 9% lower since the vote. Interest rates have fallen to record lows in world developed markets. Gold rose on fears of world financial system/currency turmoil. European equities have reached record undervaluations, lower than 2008/2009 and lower than subsequent European crises. Credit spreads have not shot up in anticipation of near term recession, but remain above normal given weak/fragile growth.
Lower interest rates affect all financial assets, so there was no change in the valuation rankings across asset classes. Non-US large and Non-US small cap equities, particularly those in peripheral European markets continue to offer the most attractive investment opportunities. Despite relative outperformance in US government bonds and US equities, these asset classes remain the most dangerous to investors from a valuation perspective.
Among individual markets, equity rallies in Russia and Brazil have made them less attractive while sell-offs in European markets and Japan have made them more attractive. The rally in gold has increased its overvaluation while Asian emerging and developed equity market resilience in the face of European troubles have made them relatively less attractive.