Dollar under downward pressure
Synchronised easy monetary policies in the US, Japan and Europe continue to generate positive economic growth surprises. Early in the year these were limited to the US, but now forecasts for both Japan and Europe are being revised upwards. This process, reinforced by the earlier and stronger rebound in emerging markets, has further to go. Such positive global synchronised growth, last seen in 1994, will put upward pressure on interest rate expectations and the risk premium component of government bond yields.
World equity markets, all of which now appear somewhat overvalued, will therefore come under downward pressure whether or not policymakers raise the actual level of interest rates, although we forecast that interest rates in the US will rise again by the end of the year, and that official interest rates in Europe (both in Euro-land and in the UK) will begin to rise in the first half of next year. Although corporate earnings expectations will be revised up, the scale of these increases will not be sizeable enough to offset likely p/e multiple contraction. Our asset class preferences for several months have been, and remain, cash first, stocks second, bonds last.
Much has been written about the “bubble” condition of the US equity market. Our view is that excessive valuation levels in the US are only a recent phenomenon. The problem now is that the level of overvaluation has risen further, while the bias of policy is clearly moving in the opposite direction. Despite our forecast of a 15% increase in S&P500 earnings per share over the coming year, we expect US stocks to fall by 10% to restore something closer to fair value. We do not, on the other hand, expect policy to tighten sufficiently to suggest that US stocks should move back into undervalued territory.
The fact that US equities are likely to fall poses a severe problem for equity market allocators. Even if other markets appear less overvalued (or even undervalued – though none does) appalling liquidity under stressful conditions almost always ensures that the US equity market will fall less than elsewhere (except perhaps Japan) even if it is the fault of the US market or events in the US to begin with. We are therefore only taking a very small underweight position in the US right now, against a small overweight position in Europe. European equity valuations are cheaper than the US but still appear modestly overvalued as a result of the recent sharp rises in European bond yields. At the same time it is not clear that earnings growth is going to exceed that of the US. Japanese equities also now appear somewhat overvalued following this year’s rally from undervalued levels, though the prospect of strong earnings recovery as a result of a combination of better economic growth and (some) restructuring is keeping us fully weighted in Japan.
On the currency side, the dollar still appears to be close to the top end of its fair value range. As positive growth revisions continue to shift from the US to Europe and Japan, so the dollar will continue to come under downward pressure, though the euro should now begin to outperform the yen. Commodity price-driven currencies – Canada, Australia, Norway – also remain attractive as global growth expectations continue to rise. The asset allocation table excludes our currency overlay, which takes overall currency exposure to US dollar –14%, euro +10%, yen –5%, sterling –3%, commodity currencies (Australia, New Zealand, Canada, Norway) +12%.
Chris Carter is with Investec Guinness Flight in London