So where are the investment opportunities as we start 2013? For us at The Headlands Group, this means “What are the undervalued markets and asset classes?” Among equity markets, the most attractive individual markets are in Europe 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 near neutral valuations. 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 areas include all maturities of US Treasuries and Emerging Market Bonds.
Central Banks – Holding down entire yield curves
As we begin 2013, the flight to quality theme continues to dominate global market pricing. In an unprecedented fashion, major world central banks are increasingly purchasing longer dated government debt, and mortgages in the case of the US Fed, to use as monetary policy tools. Their motivation is to ease the burden on major economies of dysfunctional banking systems and recovering secondary markets for debt. Greater bank capital requirements have driven banks to seek safer assets, such as government debt. Fearful investors, reluctant to take on more risk, have also contributed to the high demand for government debt. The effect of all three demand sources has been to hold down yields on all maturities of government debt, well below the levels they would typically be at this stage in the economic recovery.
Bonds – All are overvalued
Since the yields of bonds with higher credit risk are priced as spreads over the yields of government bonds, low government bond yields drive down the yield of all bonds. This has meant that all classes of bonds are overvalued, to varying degrees. Long-term bonds are more overvalued than short-term ones and government bonds more overvalued than corporate bonds. Our valuation work finds Intermediate/Short-term Investment Grade Bonds and High Yield Bonds most attractive. Non-US Developed Market Bonds also offer value, as beaten down non-US currencies offer recovery opportunities. Least attractive are all maturities of US Treasuries and Emerging Market Bonds, where strong investor demand has pushed yields very low.
Bond Risk Today – Lookout!
The primary risk for investors is that the forces that have produced excellent capital gains for bond holders and kept bond yields low will reverse and produce losses. The source of risk is recoveries in traditional bank lending and the secondary debt market. The recovery in traditional lending would mean reduced demand for government bonds from banks. The recovery of the secondary debt market means banks will be able to once again manage their portfolio risks by selling individual holdings into the secondary market and re-purchasing a more diversified basket of debt. This means banks will buy fewer government bonds and central banks will reduce their holdings, as support becomes less necessary. Stronger growth will also mean an end to near zero short term rates. As a result, all bond yields will rise and bond investors will have losses.
Equities – Under-valued and under-appreciated
In a low interest rate environment, equity investors typically pay the highest prices for a given amount of earnings. Equity prices today relative to earnings are actually below historical averages, and have been throughout the market recovery. This is particularly true in the US where S&P 500 earnings have exceeded pre-decline peaks while prices are still short of theirs. Globally, equity markets continue to see outflows as fearful investors buy bonds. Slowly returning investor risk appetite of recent months has translated into the purchase of higher yielding bonds rather than equities.
Equity Opportunities – Which markets?
Due to its relatively lower risk, compared with other world equity markets, the US market has made the most progress recovering from its 2008/early 2009 decline. Over the last few years, Europe’s uncertain sovereign debt crisis has weighed heavily on equity markets in Europe as well as other non-US markets. Our valuation work across equity markets finds the most attractive valuations in European markets and in Japan. Within Europe, small peripheral markets such as Spain, Italy, Austria and Belgium are more attractive than large core ones such as Switzerland, Netherlands and Germany. The UK and Japan also continue to offer attractive values. The US market, the largest and safest in the world, is the least attractive, having benefited greatly during the nervous recovery of the last few years. With the exception of Pacific markets outside Japan, Small Companies in all markets have recently outperformed their larger counterparts and as a result are relatively overvalued. Emerging Markets as a group are nearly fairly valued, despite having very high and very low valuations at the individual country level.