Asian clients are becoming concerned that heady US equity market valuations mean that the level of risk could outweigh further potential returns in 2018. But many participants maintain their bets on key sectors, investment managers and private bank experts told AsianInvestor.
Across the board, equity investment experts said they had concerns over US stock prices, which are riding high compared to historical averages. While many investors hope to see these prices continue to rise in 2018, the fear is that the market is becoming vulnerable to a sell-off.
“Valuation is still the most pressing concern for equity investors,” David Lafferty, chief US market strategist for Natixis Investment Managers, told AsianInvestor. “US equity valuation metrics are somewhere between extended and extreme depending on which sectors you’re looking at.”
Tuan Huynh, chief investment officer for Asia Pacific at Deutsche Bank Wealth Management agrees, noting that US price-to-earnings (P/E) ratios have climbed above their long-term average.
The Shiller P/E ratio, which is based on average inflation-adjusted earnings on the S&P 500 from the previous 10 years, touched 31.2 as of October 31, compared to the average of 16.8 since 1936, Bank of America Merrill Lynch (BAML) said in its US equity outlook report in November.
“It has already become one of the longest bull market runs of the past few decades,” Huynh told AsianInvestor, “and some caution is needed.”
Many investors share the view that the US stock market is likely to remain underpinned by solid economic growth data in 2018, but remain cautious about what to expect in terms of equity performance.
While investors aren’t exiting from the market, some have taken some profits, and many remain selective about further allocations, most experts noted. A BAML report on December 12 showed $49.8 billion of year-to-date outflows in 2017 from active US equity funds among their clients.
Apart from high valuations, any potential missteps in interest rate policy could also trigger a market correction, Huynh said. For now, most investors are pricing in three more interest rate hikes by the Federal Reserve.
Nevertheless, growth prospects for the US are expected to remain buoyant. As a result, BAML's outlook report predicts that the S&P 500 index will rise by another 5% to 2,800 in 2018. It is up around 18% year to date at 2,675 as of Friday (December 15).
However, concerns are mounting about the level of risk versus potential returns. US equities are starting to look stretched from a fundamental perspective, and that risks are firmly skewed to the downside, said Isaac Poole, head of capital market research for Asia Pacific at Willis Towers Watson.
“In the medium term, we expect equity returns in the low single-digit area,” he told AsianInvestor, “and that is not an exciting prospect relative to history.”
An unexpected rise in US inflation, coupled with changes in central bank policy outside the US, such as the European Central Bank signalling a faster exit from quantitative easing, could lead to a “taper tantrum” in 2018, noted Michael Russell, director of US equities at Hermes Investment Management.
The so-called taper tantrum happened in 2013, when the Fed unexpectedly announced it would begin winding down one of its quantitative easing programmes. It triggered a debt sell-off that sent bond yields soaring.
A similar surge in treasury yields would increase borrowing costs for companies and consumers, Russell explained, as well as impact growth companies that depend on capital markets to raise money.
Natixis’ Lafferty is in the more optimistic camp: he sees little pressure on US P/E ratios as long as the global economy continues to grow.
“This is one giant short-volatility trade, a bet that the market will continue to grind higher,” he said, "and valuations, central banks, and geopolitical risks don’t matter provided the earnings continue to materialise.”
Some opportunities exist
While Asian investors prefer to invest in regional equity markets, they continue to see selective opportunities in US stocks, said Huynh.
“The US remains the favourite region for investing abroad,” he said, adding that Deutsche PWM’s clients are primarily invested in sectors such as technology, banks and healthcare.
Asian investors are also investing in US equity through global equity mandates rather than country-specific ones, to reduce exposure to risk, said WTW's Poole.
“They are using a pool of highly active equity managers, which complement each other to ensure they are not overly exposed to any single factor, style or industry compared to the market as a whole.”
Hermes' Russell also saw positives in the technology sector in 2018. “We believe technology spending as a percentage of GDP could rise for decades to come,” he told AsianInvestor. “The so-called Fang [Facebook, Amazon, Netflix and Alphabet, Google's parent company] companies look like winner-take-all industry models and trade on attractive P/E ratios.”
The Fang group has brought investors big returns in 2017, with stock prices soaring between 30% and 50%.
Information technology spending in the US is expected to grow by 4% in 2017, second only to Asia ex-Japan's growth in spending, a July report by technology consultancy IDC said.
The financial sector also offers good opportunities for investors, according to Natixis’ Lafferty. “We still find financials and banks to be the most outright undervalued area of the market,” he said. Banks are trading at around 12 to 13 times forward P/E, Lafferty explained, while the overall market is trading closer to 18 to 19 times.
Returns could be bolstered by lending growth if the economy continues to strengthen, he added. Banks should also benefit from higher rates, Hermes’ Russell said, as well as a more benign regulatory framework.
There is an outside risk that the Fed will have to take more aggressive actions if inflation finally shows up, Natixis’ Lafferty said, which might cause the US dollar to raise in value.
However, he doesn’t expect that to be an issue in 2018. “While we expect the US dollar to appreciate modestly,” Lafferty noted, “we don’t think the rise will crimp US equity earnings enough to impair returns.”