The FOMCÆs decision to lower the target rate acknowledged the growing downside risk to growth stemming from deteriorating financial market conditions and uncertainty in the housing market. Financial markets welcomed the move with equity markets performing well, and spreads in credit derivative markets narrowing, suggesting that tensions in corporate bond markets may start to recede. However, while the VIX index of implied volatility for the S&P 500 also took a step back from high levels, volatility is likely to stay above-average in light of the continued uncertainty surrounding the US housing market.
We recently advised clients to reduce their bias towards equities, after markets had recovered losses incurred in August. Nevertheless, while the weighting of equities relative to bonds has been reduced, we believe global equity markets continue to warrant preferential treatment. However, the way to play equities in terms of what regions and what styles will become even more decisive going forward.
Focus still on US housing
Given the impact of developments in the US housing market on global credit, it comes as no surprise that investors continue to monitor the market closely. The crucial question is whether the negative news that is likely to emanate from the market over the coming quarters will be offset by other factors, including the FedÆs pre-emptive move. There is no question that market volatility will continue. What is less easy to predict are the factors which will determine the fate of risky assets going forward?
First, given the retreat in US consumer spending, investment spending together with demand from abroad both have the potential to be major pillars for US economic growth and help avoid a plunge into recession. Globally as well as in the US, the corporate sector is healthy with sound balance sheets and strong cashflows.
At the same time, high capacity utilisation in the US suggests the need for companies to engage in capital spending, which should also be supported by low interest rates. While, in terms of foreign demand, recent export and import data suggest that the US current account has arrived at an inflection point, as export growth has started to outstrip that of imports. Of course, a weak US dollar will also play an important role in the international competitiveness of the US.
Second, the scope for central banks to ease monetary conditions will be crucial and will rest, to a large degree, on the outlook for inflation. Should inflation indicators remain muted, then investors should be rewarded for betting on central banks to keep the global economy running. Recent rises in food and energy-related prices have stimulated discussion on the longer term outlook on inflation but it is important to note that core inflation in most countries û excluding volatile food and energy prices û is still low. Any moderation in global growth should reduce future inflation risks.
Still, there is not much room for complacency, and we do not believe that investors should take further strong supportive Fed action as a given. Further easing is likely only in as much as it is a counterbalance to increased growth risks, and whether the net balance for risky assets will be positive is, at this juncture, uncertain.
Third, and most importantly, the strength of the global economy ex-US will be the key differentiating factor in this cycle. Indicative of the importance of ex-US growth has been the resilience of Asian equities during the recent market turmoil. It is true that Asian equities have experienced a roller coaster ride, but the upward trend was never broken as in other regions, as investors' seem to take increasingly heart in the Asian growth story. Besides Asia, Europe also has started to show more domesticbased growth dynamics with labour markets improving. All of this provides hope that the US will receive support from the economic strength of other regions.All this suggests that the world economy is at a crossroads which will decide over the continuation or sudden end of the economic cycle. Should a recession in the US be avoided, and global growth remain robust, we are confident that global equities will not disappoint. As this is our base case scenario, we continue to have a global bias towards equities, albeit reduced after the recent rally, relative to other asset classes. However, investors should be prepared to identify pockets of remaining value as well as markets in which prices already exceed those justified by fundamentals.
In this respect, we continue to find good value in larger capitalisation stocks in the US and Europe. In addition, we prefer growth to value stocks. Notwithstanding the outperformance of small-cap and value stocks over recent years, we believe, that as we enter a phase of more modest earnings growth and tighter financing, this is likely to change.
In general, we prefer global companies which we believe are likely to continue to benefit from the opportunities offered by an integrating global economy û for Asian-based investors, global US companies might be an attractive investment opportunity on a one-to-two year time frame. Our view is based not only on the currently cheap currency but also on to the opportunity to tap into domestic growth via international companies, which also provides diversification from local risk factors, both regulatory and corporate governance-related.
More speculative plays
However, after almost five years of strong performance, not all higher-risk assets continue to represent good value. Particularly speculative is the Mainland Chinese market, where strong price advances have been buoyed by regulatory restrictions on capital flows. However, even H-shares traded in Hong Kong are now at levels where speculation appears to be driving investment decisions. Valuation support has also been eroded in India. Instead, on a regional basis we see better price support in South Korea and Indonesia.
That a market is driven more by speculation than value does not necessarily imply no further upside over the short term, as bull markets tend to lead to an overshoot of market prices above fair values. However, it is important that a disciplined approach is maintained with this type investment û stop-loss rules should help to maintain risk control. In this respect, playing gold might start becoming a speculative trade should prices continue to spike.
One possibility is that we will see accelerating positive price momentum as more and more investors enter this market. This might offer very attractive returns over the shorter term for investors who are willing to accept the risk. However, a stop-loss strategy will limit the downside risk, and investors might also want to apply a strategy which, from time to time, locks in gains as the bubble builds.
Currencies: Value versus carry
In the currency space, a key question is whether to engage in the carry trade û financing investments in higher yielding currencies by borrowing in low yielding money such as yen or Swiss franc û or take note of the readings from valuation gauges, such as purchasing power parity? Those indicators suggest that higher yielding currencies such as the Australian dollar are significantly overvalued.
At this juncture, we prefer to listen to value, as valuation gaps have become extreme, suggesting significant currency risk in investing in high-yielding currencies. With regard to Asian currencies, we believe the yen and the Chinese renminbi are undervalued and expect both currencies to appreciate over the longer term and so offer significant re-valuationpotential especially against the euro, and to a lesser extent, against the US dollar. This should also lead other undervalued currencies in Asia to appreciate.
The art of diversification
To conclude, given the weakness of the US economy, the world economy is at a crossroads and it remains to be seen whether other regions can maintain growth momentum and so buoy the global economy. As long as the outcome is uncertain, and the lagged effects of the recent credit crisis are not fully accounted for, volatility in asset markets are likely to remain high. It is, therefore, more important than ever to diversify across asset classes and markets.
We think that after the late summer sell-off, credit markets again offer opportunities to diversify also into interest rate instruments. Within equities, we recommend that Asian investors look outside the region for diversification opportunities. We especially like large, global companies in the US and continental Europe with international exposure.
Walter Edelmann is head of global investment strategy at UBS Wealth Management Research.
This story first appeared in the latest issue of Private Capital, which was distributed with the November issue of FinanceAsia magazine.