Desperately Seeking Value
Developed Market equities – particularly US stocks – range from fairly-valued to overvalued. And indeed, the risk of a correction, which we had expected last quarter, remains high. Yet, the global economy continues to grow with reasonable strength, interest rates remain historically very low, and political risks appear containable. All of which means a bear market is also unlikely – neither feast nor famine.
So that’s the dilemma facing investors today. Staying in cash at these low rates remains unattractive. Waiting for a “big crash” to bring out your cash hoard is likely to be a long and wasteful exercise. So investing is a more delicate and discerning business today.
US equities’ cyclically adjusted price-to-earnings (CAPE) ratio is now approximating two standard deviations above a 134-year average. That’s dangerous overvaluation territory – a market priced for perfection. Against that, expectations of what US President Donald Trump can do for US stocks now appear unrealistic, considering that he has been politically damaged and is distracted by investigations into whether he had attempted obstruction of justice, and whether key members of his team had improper dealings with the Russians.
European equities are not cheap either. But at least, it would be more appropriate to describe them as fairly-valued rather than overvalued. And European economic data has been surprising on the upside, while it has been disappointing in the US. Meanwhile, the cost of money will remain cheaper for longer in Europe vis-à-vis the US; European Central Bank (ECB) quantitative easing will continue at least until the end of this year while the Federal Reserve could start reducing its balance sheet later this year or early next year; and political risk has eased significantly with Emmanuel Macron’s victory in France.
Asian equities offer better value. Their forward price-to-earnings ratios (PE) trade in the early- to mid-teens and are in the middle of their cyclical ranges. Economic growth in Japan is picking up from the borderline recessionary conditions of 2016. Meanwhile, the continuation of a negative policy rate combined with quantitative easing should see the yen weaken anew against the dollar, helping boost corporate earnings in local currency terms. Asia ex-Japan equities could be coming into a “sweet spot”, with economic growth stabilising after years of decline, inflation taming, and economists’ forecasts rising since the start of the year. Corporate earnings are still at an early stage of recovery from the protracted recession that ended late last year.
So it’s a mixed picture for equities globally, demanding a very discriminating approach.
For fixed income, there is a clearer, more unified theme – the end of monetary accommodation. It has started in the US, where the Fed will continue raising rates and soon start reducing the size of its balance sheet. Sometime this year, speculation over ECB tapering its asset purchase program and exiting its zero policy rate could start putting upward pressure on bond yields. Globally, inflation will continue to gradually pick up. And corporate bonds – with spreads as tight as they are at the moment – have likely seen their best.
Commodities are cheap. But global oversupply has yet to fully unwind, and sentiment remains bearish. Yet, from a longer-term perspective, this is probably a good time to take a small position in commodities. Global economic growth is strengthening, albeit modestly. And supply is being worked down, albeit slowly. So there are cycles. And commodities – particularly industrial metals and crude oil – are probably close to the bottom of their respective cycles.
In currencies, the unwinding of Trump-related expectations – particularly fiscal divergence between the US and others – may have run its course. And the next six months is likely to see a resurgence in the dollar on monetary policy divergence. Leaving aside the now ambivalent prospects for substantial fiscal stimulus in the US, economic and inflation differentials still call for higher US rates and yields against most major economies. We see a stronger dollar against most currencies.
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