US stock markets are fully but fairly priced in today's environment of low inflation, economic expan...
US stock markets are fully but fairly priced in today's environment of low inflation, economic expansion, and robust earnings. US bond prices are set to decline further as the Federal Reserve Board begins to tighten, but investor sentiment may overshoot on the downside, creating opportunities.
The big cyclical surge in equities and the Fed-fuelled rally and spread narrowing in bonds are largely behind us; return expectations for both asset classes over the next three to five years are modest (though greater than cash). In the current context of benign equilibrium, this is not a time for large asset class or sector exposures. However, asset allocation models have recently begun to signal a moderate preference for large-cap over small-cap stocks. This view is based on historical evidence suggesting that large caps outperform as the economy transitions from recovery to expansion.
Within an overall strategy of broad diversification, a neutral allocation between stocks and bonds is favoured; within equities, a bias toward higher-quality, dividend-paying issues and geographical diversification; and within fixed income, an emphasis on multi-sector strategies.
The spectre of Fed tightening may create medium-term opportunities to establish or augment a bond exposure.
Historical patterns of past Fed tightening cycles suggest that market participants will price in Fed actions too aggressively. This pattern of behaviour, together with the unwinding of carry/laddered strategies, offer the conclusion that increasing bond exposure may be a wise move in six to 12 months' time. High-quality stocks will eventually regain market leadership.
The timing of this shift is unclear, but it is inevitable, in our view, given wide valuation gaps between high- and low-quality stocks, as defined by return on equity, in a context of moderating economic growth and tax code changes favouring dividends. This is not, by the way, an undiscriminating, across-the-board call for dividend-paying stocks driven by tax considerations. One part of the definition of a 'quality' company is that it has reliable and growing earnings, and is able to pay a dependable and rising stream of dividends to its shareholders.
There is scepticism about the likelihood of a near-term resurgence in inflation and, therefore, about most investment strategies based on this supposed threat.
Labour is the single-largest component of US production costs for goods and services. Since the start of the current economic expansion, productivity (output per hour in the non-farm business sector) has risen at a 5% annualised rate, the strongest sustained surge since 1950. Yet average hourly earnings have grown just 1.8% over the past year, one of the lowest rates in four decades of Labour Department record keeping. These two trends have combined to spark the biggest cumulative decline in unit labour costs since World War II. And with this major component of costs dropping in a competitive economy, it is very hard to see overall prices of goods and services taking off.
For this reason, inflation-protected Treasury securities (Tips) or real-estate investments trusts (Reits) are not favoured. Tips are too small, illiquid and untested a class of securities to constitute a major portfolio allocation for the prudent investor. Reits enjoyed stellar performance for more than three years before their recent retreat, but current valuations are too rich. Fresh performance-chasing capital keeps pouring into the asset class even with high vacancy rates for non-residential properties.
The exception to our general scepticism about inflation is in commodities, particularly oil. Although manufacturers around the world are becoming more energy efficient, rising demand for oil, especially from high-growth areas like China and India, along with stagnant production volumes will exert sustained upward pressure on prices.
The Canadian economic cycle has been out of sync with the US cycle for the past several years. This creates a near-term opportunity in Canadian versus US bonds, as the Bank of Canada will lag the Federal Reserve Board in tightening monetary policy.
January data on Canadian GDP growth indicated that the Canadian economy contracted at the start of the year, in sharp contrast to robust US economic expansion. While this does not necessarily imply a near-term easing in Canadian monetary policy, it does suggest the Bank of Canada will be reluctant to follow closely on the heels of Fed tightening with interest rate increases of its own. Without having to confront the headwinds of Central Bank tightening, Canadian bonds may well outperform US bonds in coming months.
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