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.
Having gotten past major uncertain events expected in 2016, several Fed meeting outcomes, the Brexit vote and the two major party conventions, financial markets are now just left with an unprecedented presidential election and two more Fed meetings. Continuing near term uncertainty and weak economic recoveries globally encourage ongoing aggressive levels of central bank support. Major central bank bond purchases continue to distort bond market pricing globally. As a result, yield to maturities on major government bonds do not compensate investors for expected inflation or sovereign credit risk. This affects pricing on all bonds, propagating from low risk government bonds to high risk corporate debt. Credit spreads, compensation for credit risk, have fallen to below-normal levels, as investors have been willing to accept significantly higher default risk for only modest additional compensation. These developments have made all bond markets/asset classes overpriced, constraining the expected return of new bond investors. Investors are increasingly being compensated less and less for growing interest rate and default risks. In this environment, it makes sense for investors to hold shorter maturity bonds and limit low quality credit risk.
Among world equity markets, developed markets in Europe and Japan offer the most attractive pricing. To the extent that the US equity market is priced richly, reducing expected return, these markets are priced cheaply, increasing investor expected returns. False starts economically in both Europe and Japan continue to frustrate investors, so equity pricing there has remained attractive. Small Cap stocks are generally priced above their large cap counterparts around the world – offering less attractive value to investors. Emerging market equities have rebounded strongly in 2016 on a recovery in oil prices and a benign Federal Reserve, which at the start of the year had threatened to contract liquidity around the world. Their rally has left them modestly overvalued at the end of the third quarter.
