Beneath the surface, however, there are nuances to this view. The AAC has begun to identify opportunities as its outlook gets firmer. The clearest example is our less-than-favorable view on the important U.S. large-cap market. With 2019 S&P 500 earnings growth projected to come in around 3%, according to FactSet, and the forward price-to-earnings ratio having already leapt from 14-times to 17-times in the first half of the year, we think there is limited scope for further appreciation, relative to some other markets.
In short, U.S. large caps appear fairly valued to us, whereas other markets appear somewhat undervalued. To identify those other markets, we think it helps to envision a potential future rotation from low-beta to high-beta exposure, and from low to high global exposure.
For example, the AAC has maintained its overweight view on Directional Hedged Strategies while moving to a neutral view on Lower-Volatility Hedged Strategies. This is largely a recognition of the poor opportunity set in relative-value and arbitrage strategies when correlations are so high and interest rates are so low, but it also reflects members’ willingness to retain some beta within its overall view on alternatives. The AAC has upgraded its view on U.S. small caps, which have lagged large caps by 16 percentage points over the past year, as they can be a good source of high-beta exposure, especially if we see an eventual recovery in risk appetite and inflation that is accompanied by higher energy prices.
A little more tentatively for now, but something to watch, is the AAC’s view on Japanese and European equities. Today these trade at similar valuations as the S&P 500 six months ago, and they can bring a combination of both high-beta and high global exposure.
We do not think that Japan’s domestic economic indicators have bottomed-out yet, and the proposed sales-tax hike in October will likely be an additional headwind. But Japan’s stock market is much more tightly geared to the global than the domestic economy, more so than any other developed market. Share buybacks are currently running at their highest levels since 2006, reflecting attractive valuations and insiders’ expectations for upward earnings revisions later this year.
In Europe, by contrast, the domestic challenges that have dominated risk in the past decade have been receding for some time already. The banking system, lending levels, employment, wages and consumer confidence have been improving steadily for two years or more. Earnings and equity market multiples have been held back by rising tensions around global trade and specific problems for the auto industry.
As in the United States, there has been extreme divergence between the performance of defensive and pro-cyclical sectors in Europe, with the latter pricing in an environment of persistent zero growth. Should trade tensions cool, inflation stabilize and global financial conditions improve, this will likely look overdone. It is notable that, just as the U.S. Manufacturing Purchasing Managers’ Index (PMI) has entered a steep decline, the Euro Zone Manufacturing PMI appears to be bottoming-out. The same bottoming-out is evident in Europe’s pro-cyclical stocks. The AAC’s marginal downgrade to a neutral view overall on non-U.S. developed market equities conceals, beneath the surface, a cautious but firming bias in favor of more cyclical, globally geared sectors.
An easing of trade tensions between the United States and China, together with a shift in the balance of risks toward a weaker U.S. dollar, might also be expected to benefit emerging economies. Emerging markets have lagged U.S. large caps by some seven percentage points so far this year. The AAC remains cautiously optimistic that China’s stimulus efforts will continue to gain traction and return us to the upside data surprises that characterized the first quarter of 2019. While a weaker dollar would be a tailwind for emerging market equities and currencies, supporting the Committee’s overweight views on both asset classes, members also noted that growth concerns weigh a little heavier here than in non-U.S. developed markets.
Given our core outlook, it is inevitably more difficult to find places to spend risk budget in fixed income. We favor inflation-protected securities, where we believe deflation fears have left attractive valuations, even if inflation turns out to be weaker than we anticipate (see “Up for Debate: Are We Finally Going to See Some Inflation?”). The only other places we find attractive for sovereign risk are emerging markets and the southern euro zone—again, these are higher-beta exposures that leaven the general underweight view in fixed income and credit.
The AAC is favorable toward high-yield bonds and loans, where supply-and-demand technicals are supportive, but it sees particular value in high-quality, BB rated credits as the market becomes more discerning on fundamental risks. This view is also supported by the fact that the relative value case for emerging markets hard currency debt against U.S. high yield is not as clear as it has been over recent quarters.