As regular readers and clients know, our sense leading into the US elections was that the internals of the stock market, US Treasury yields, US dollar and gold suggested that the odds of a strong Republican performance were better than the mainstream media and polls had indicated. The performance of the Donald and the Republican Party was emphatic. We also noted that this was likely to be positive for the US stock market as investors priced stronger potential growth, lower taxes and less regulation.
Of course, we also noted that the consequence of these policies might be a higher path of interest rates. In the near term, the markets would likely rejoice at the prospect of stronger growth. However, the higher path of interest rates and a renewed bond term risk premium might prove to be a challenge for equities and credit over the coming months. The context, as we have noted for some time, is the absence of an equity or credit risk premium. While implied volatility had increased in the weeks leading up to the election, it remains low by historical standards.
It is an obvious point; however, bond and equity prices are related to each other. Put another way, the earnings yield on equities is very low relative to the 10-year Treasury yield. To be fair, equities are a growth asset, and earnings ought to grow over time and might expand more aggressively under a more market friendly administration. Nonetheless, risk compensation on the S&P500, the global risk proxy, remains poor.
In Asia, the key beneficiary of stronger potential global growth is Japan. First, the valuation starting point is inexpensive (our sub-portfolio trades on 8.5 times forward earnings). Second, Japan has the highest sensitivity of EPS to global industrial production of any of the major markets. Third, a stronger US dollar and a higher path of rates ought to be bullish for the US dollar relative to the Japanese Yen. Finally, Japan is an ally of the United States.
The good news for the other markets in the region, notably China, is that valuations, expectations, and positioning are already low. Any pessimism from trade conflict is already well appreciated and priced. We also see Southeast Asia (including Vietnam) as a beneficiary. While we retain a moderate net equity exposure, we are 15% long Japan, USDJPY and long Southeast Asia including Japan. However, we fear that the Donald will also Make Volatility Great Again. In that context, risk premia are now, and the cost of protection (especially in credit) is underpriced.
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