The correlation of asset classes in recent years has made investing more difficult for those seeking growth in the current environment.
In an era of low interest rates investors have increasingly been pushed towards riskier assets as traditional asset classes have seen valuations rise ever higher.
Indeed, analysts have suggested that high valuations could be sustained as the conditions that have buoyed risk assets look unlikely to change.
“Equity markets globally remain in fine fettle, with the MSCI Emerging Markets index at a record level and the MSCI World index within a whisker of its all-time high,” noted Capital Economics chief markets economist John Higgins and assistant economist Oliver Jones.
Performance of MSCI Emerging Markets vs MSCI World over 1yr
Source: FE Analytics
“Equities’ recent strength is due in part to price/earnings [P/E] ratios climbing well above their historical averages. But we don’t think that valuations have become unsustainably high.”
The pair noted: “Higher valuations have been supported by a structural decline in real interest rates, which we think is likely to endure.
“This decline has cut the prospective return from ‘risk-free’ assets, demonstrated by the historically-low levels of developed-market government bond yields.”
They added: “In our view, this has driven the equilibrium valuations of risky assets some way above the long-run averages with which they are frequently compared. With this in mind, we believe that investors’ exuberance for such assets is rational.
“Admittedly, we think that the upside for risky asset prices is limited. Indeed, our forecast is for the US S&P 500 to end next year a little lower than it is now.
“What’s more, although we expect equities elsewhere in the world to rise, we are not forecasting especially large gains.
“But we judge that a major correction is unlikely before 2019. And even then, we suspect that it will be caused by the rising risk of a cyclical downturn in the US economy – not by markets collapsing under the weight of excessive valuations.”
Yet, not all market watchers agree. Managers and asset allocators have urged investors to remain cautious in the current environment.
Luca Paolini, chief strategist at Pictet Asset Management, said while riskier asset classes continue to draw support against a backdrop of reasonable global economic growth and ongoing monetary stimulus, investors should remain wary of current valuations.
He said the equities rally has begun to lose steam more recently as economic growth has also appeared to plateau. Additionally, Paolini highlighted recent noises by central banks that are “slowly but steadily” planning to withdraw stimulus.
“The onus is now on equities to justify their strong performance after a spectacular run, with suitably strong earnings numbers. Expectations are running high, particularly in the US in turn raising the risk of disappointment,” he said.
“The consensus view on US earnings implies real GDP growth in excess of 3 per cent - which has not been seen in over a decade. This is in stark contrast with economic realities.”
Paolini said the asset manager was neutral on equities and underweight bonds, although it did continue to see attractive investment opportunities in some areas of the asset classes.
Turning to equities first, “both Europe and Japan are favoured over the US, with economic and earnings cycles converging,” he said.
“Prospects for eurozone equities look particularly bright thanks to improving economic prospects; we also like UK equities – they offer a sizeable dividend yield while the market’s multi-national constituents earnings should draw some support from a weak pound.
“Japanese stocks, meanwhile, boast attractive valuations relative to the US, underpinned by a still very expansionary Bank of Japan.
“Emerging markets equities offer long-term value and should benefit from a weaker US dollar, but they look a little overbought after the rally and strong investment flows. Thus, we retain our neutral stance.”
Within the equities sector, Paolini said the firm had trimmed exposure to cyclical stocks as the global growth had slowed. He said telecoms, energy and financial stocks offered best value but the firm could cut its exposure if the global economy slowed further.
As for bonds, Paolini said the firm had found opportunities in the US Treasuries space – having upgraded it from a neutral to overweight position – as the Federal Reserve mulls further monetary policy tightening against a backdrop of rising inflation.
“Elsewhere, we remain underweight eurozone, Japanese, Swiss and UK bonds, all of which look expensive,” he said. “We are still overweight in emerging market local currency bonds – economic activity remains solid and inflation is slowing, allowing an easing of monetary policy. Any further drop in US Treasury yields and the dollar should also support local currency debt.
“We retain our underweight stance on the dollar – it has already dropped 10 per cent from its highs and has further to go. Emerging market currencies are well-positioned to benefit from dollar weakness.
“The European Central Bank looks uncomfortable with the euro’s appreciation and whilst we retain our overweight, we’ve reduced our position on the Swiss franc, a euro proxy, from overweight to neutral.”
Eugene Philaithis, portfolio manager on Fidelity International’s multi-asset range, said it too had moved to an underweight position on the dollar.
“The US dollar has continued on its downward trajectory that began at the turn of the year,” he said. “With US data weaker than expected in the immediate aftermath of last year’s US election, investors have reassessed the outlook for global monetary policy and how far ahead the Federal Reserve is in raising interest rates.
Performance of sterling & euro vs US dollar YTD
Source: FE Analytics
“This has weakened support for the currency, especially against the likes of the euro, with markets also re-pricing the potential for tax reform and other forms of economic stimulus.”
Philaithis said exposure to the US dollar in its five FE Crown-rated Global Multi Asset Income fund had reached its lowest point since the fund’s inception.
However it added exposure in May as it took some profits from positions in the Japanese yen, Swiss franc and Australian dollar.
“As it’s a safe haven currency, we might further increase exposure to the dollar in future by adding from currencies like sterling and the Hong Kong dollar,” he added. “These have weaker prospects against the dollar than areas like the euro or emerging market currencies, which benefit from strong fundamentals and good valuations.”