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Watch the videos as Robert Rountree, our Global Strategist shares his insights of the drivers behind the rallies and the value opportunities in equities.

Both equities and higher yielding bonds have been key beneficiaries (Fig.1), each being prodded forward by an unrelenting weight of money.

Emerging and Asian market equities have, additionally, been aided and abetted by earnings upgrades, firmer commodity prices and a US Dollar that has noticeably cooled2.

With many equity markets having risen significantly, it is possible that markets will see some consolidation as investors not only “rest” but also succumb to the temptation to lock in a few profits. Abundant liquidity and many “fair” valuations suggest that most markets should be able to absorb any such selling.

Overall, the drivers behind the rallies look to be intact.

Fig 1: Asia (ex. Japan) heads the 2017 charge

Yield gap pendulum swings in equity’s favour

Taking the strategic view, low redemption yields and the much reduced prospects of bond capital gains have swung the investment pendulum firmly in favour of equities (Fig.2).

This yield gap will close, but will it close due to either an equity rally or a bond sell-off? The former seems more likely given the sustained growth in global liquidity, which should not only drive equities higher but also support expensive bonds. The investment pendulum favours equities both tactically and strategically.

Fig 2: Equity rallies will likely close the yield gap

The money wall spurs on investors

The higher markets move, and the higher valuations rise, the greater the significance of the underlying liquidity. Indeed, high liquidity probably accounts for much of the resilience in the volatility index despite rising geopolitical risks.

The liquidity injections seem set to continue. Although the US Federal Reserve Board (Fed) has ended its quantitative easing program, other Central Banks3 have continued injecting liquidity, which has inevitably “leaked” into the wider world. Global liquidity “free” to invest in fi nancial assets is growing at a steady clip4. It is difficult to under-estimate the impact of this historically high level of liquidity. It played a major role in stabilising 2013’s “Taper Tantrums” as it cushioned, then reversed, investor fears that retreating liquidity would undermine the markets.

The situation is changing; liquidity fears could re-emerge. The US Fed has already announced plans for shrinking its balance sheet. The European Central Bank and the Bank of England have hinted at following suit, at some point.

Investor reaction to the US Fed move has been limited probably because the Fed’s balance sheet as a percentage of GDP will shrink from only 26% as of the fourth quarter of 2017 to a projected 23% by end of 20185.

Being in uncharted territory, Central Banks are moving cautiously. The resulting picture is that global liquidity will remain supportive. The situation should be monitored.

Investors, however, have already discounted in good measure, the 2017 potential rise in US rates6. The Fed has less room to manoeuvre than many expect despite its declared intention to hike rates once more this year.

Overlooked in the much lauded US jobs data, for example, is the strong bias towards the over 55-year olds7; rising jobs and wage bills may not feed retail sales to the extent of the past, (which may explain the recent sharp fall in the Citi US Economic Surprise index8).

The underlying picture is that the volume of money, not its price, is in the driver’s seat.

Emerging and Asian markets lead earnings upgrades

High global liquidity is not the only factor driving financial markets onwards. As the world economies move into a cyclical upswing, profit forecasts are rising in tandem. The omens are that declared profits could well surprise on the upside, a reversal of the past two years (Fig.3).

Fig 3: The global earnings cycle swings upwards

Such positive “surprises” have already manifest themselves in Japan where investors, focused on the economy rather than companies, have underestimated the profi t rebound9.

Skeptics may argue that many equities are fairly valued10 only because of the strong earnings upgrades seen over the past six months.

That many results outstripped their forecasts blunts this argument. But, there is little leeway for disappointment in the US given stretched valuations there.

Asia beckons

Globally, fairly valued opportunities abound, despite the strong rallies year to date. Indeed, there are many attractive opportunities especially within Asia and some Emerging Markets.

Fig 4: Asia looks attractive…even after this year’s rallies

Valuations for Hong Kong’s “H” shares, for example are still well below their 10-year average, which is probably an over-discounting of China’s banking/ property/currency concerns.

Asia’s high dividend stocks, too, have been ignored as investors have swung towards growth and momentum.

US equity valuations, in contrast, leave little room for disappointment. They will likely remain supported, however, by a prospective earnings yield of around 5½%11, earnings forecast upgrades and on-going liquidity. While the economic cycle is in its upswing, much of the good news appears discounted.

Eurozone equity valuations look stretched on similar grounds. Nevertheless, they too, should find support not least because of their discount of more than 40% to US equities, the largest gap since 1989. Eurozone equities should also benefit from rising US rates given their higher exposure to the banks and cyclical sectors. Growth and profits have already materially improved on a forward looking basis.

Relative to the other developed markets, Japan’s lower valuation looks very attractive (albeit in line with its 10-year average). Investors may remain cool to this fact, being influenced by the on-going tug-of-war between the success (or otherwise) of “Abenomics” and the fruits of corporate restructuring. The extent to which declared profits exceeded their forecasts in the recent announcements season, has accelerated the upgrade momentum in the profit forecasts, which could yet reflect in higher valuations.

Despite these positives, it is difficult to ignore Asia’s and Emerging Markets’ attractive valuations. The omens look good for both not least because they are benefiting from a hitherto unexpected tailwind.

The US Dollar: From headwind to tailwind

One major reason for both Asia (ex Japan) and the Emerging Markets being badly hit prior to 2016 was the impact of the strong US Dollar; investors exaggerated US Dollar debt fears12.

Since end 2016, the US Dollar has fallen over 5%13. Asian and Emerging Markets have rallied strongly.

The issue is whether US Dollar weakness will continue. Bearing in mind the heavy discounting of future US rate rises, the answer to the US Dollar’s direction probably lies in the supply. With the Fed’s QE program ended, one must look to the relative size of the combined US budget and current account balances for the answer. These “Twin Deficits” exert a powerful influence on the US Dollar, albeit with a variable lag.

Based on the consensus forecasts for 2017 and 201814, the “Twin Deficits” are rolling over15. The message is that the dollar is has peaked; any dollar strength on US rate hikes could well be short-lived. Should President Trump push through significantly larger budget deficits as many fear, the US Dollar could fall further.

Whatever the outcome, a major impediment to Asia’s and the Emerging Markets’ rising appears to have been removed: good news for equities and local currency bonds.

Earnings. Liquidity. Valuations. Pulling it together

Asian and emerging market equities, in particular, stand out as being attractive. Despite this year’s rallies, the massive over-discounting of the preceding years has only been clawed back (partially in some instances) with little premia, attached to the higher earnings forecasts.

While investment cases can be made for both the US and Eurozone equities, a fair measure of the good news has been discounted. Earnings yields, while low, have been lower, but there is little room for slippage in earnings delivery. Of the two, the Eurozone looks relatively better value.

Amongst the developed markets, however, the strategic case for Japan remains the more compelling. Corporate restructuring and profits outstripping forecasts both support higher equity valuations16. Valuations are in line with the ten year average.

The outlook for bonds remains little changed from the start of the year. Liquidity should support the expensive, “safer” end of the curve, while, at the same time, prodding investors (in search of yield) towards the higher end of the risk spectrum.

Within this dynamic, Asian bonds in general offer a yield premia over their US (and most global) equivalents. Asian investment grade credits, in particular, still offer a premium in line with their 10-year average. This income pickup looks attractive particularly given that interest rates will unlikely rise sufficiently to dilute bond’s coupon appeal. A peaking dollar makes many emerging market local currency bonds look attractive.

With high liquidity underpinning markets, we reiterate our January mantra, “The Biggest Risk is No Risk”.


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