Despite historically low global inflation and increasing prospects for global economic growth, the s...
Despite historically low global inflation and increasing prospects for global economic growth, the signals from the traditional equity and bond valuation tools remain exceptionally unclear.
In spite of the recent setbacks global equity markets, most notably the US, are trading well above their fundamental fair value levels. Although corporate earnings expectations have improved, the decline in global bond markets has eroded an important prop for equity market valuations. While a severe expansion in credit risk premium has occurred in the bond markets, equity risk premium remains historically low.
This presents a paradox. It suggests that either corporate bond yields are massively undervalued and the level of risk aversion is too high, or that equity markets are massively overvalued and the risk premium is too low. We believe the truth of the matter lies somewhere in between.
The key remains with the US monetary authorities. Alan Greenspan has underlined his willingness to head off any inflationary risks and has explicitly raised concerns over both equity market valuations and the need to avoid a Japanese-type asset price bubble. The constraint, which has prevented the Fed from raising interest rates in a firm manner, has been the fear that a reaction in the form of an extreme equity market correction could lead to a retrenchment of the US consumer.
Both unrealised equity gains and inflated views of future gains from consumers' equity market investment plans largely dictate spending. A prolonged correction would impact on sentiment, causing consumers to stop spending and potentially leading to recession.
A sharp slowdown in economic activity in the US relative to the rest of the world would lead to a significant exodus of foreign investment which in turn would undoubtedly cause a sharp fall in the dollar and require the Fed to raise rates. A severe monetary tightening would have a disastrous impact both for US capital inflows, the dollar and global financial markets.
Within this uncertain environment we would advocate caution. Global bond markets will continue to be influenced by the fortunes of the US Treasury market. Currently the market is becoming more and more fragile as larger capital inflows are required to maintain the rapidly expanding US trade deficit. As long as the dollar remains firm and relative economic growth remains ahead of other regions, this situation will remain tenable.
Despite the dangers, at current market levels we believe equity markets remain the relatively more attractive asset class while preferring the safe qualities of cash to bonds. We prefer Europe and the UK, and in Japan and Asia, we have still to be convinced the fundamentals are in place for a sustainable rally.
Peter O'Reilly is fund manager at Royal & SunAlliance Investment Management.
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