US equities, corporate bonds attractive for TAA

Asian economic growth set to continue but the regionÆs valuations look stretched, argues Prudential Asset ManagementÆs Kelvin Blacklock.
Equities offer more value than fixed income, and within equities, the United States market is now more attractive than Asia, says Kelvin Blacklock, CIO for regional fixed income and balanced funds at Prudential Asset Management in Singapore.

He made his remarks on tactical asset allocation at a conference in Dubai for PrudentialÆs distribution channels in Asia Pacific.

Global markets have been in a ôsweet spotö for the past several years, and this summerÆs subprime blow-up has led to widespread concerns that the party is over. While an era of free and easy credit is over, this doesnÆt mean credit wonÆt be available for the majority of borrowers.

Blacklock notes that in August, Rio Tinto secured a $40 billion loan. ôAny company that needs the money can still borrow,ö he says. But credit is being extended on a more conservative basis û which is ultimately good for the markets.

Meanwhile he remains optimistic about the prospects for global economic growth to continue to grow and for interest rates to remain low. Corporate leverage remains low. Therefore he prefers equities to bonds, because equity valuations remain fair or cheap, and earnings expectations are not excessive.

He acknowledges that many stock markets have bounced back this summer. On a global basis, prices are now as high as they were at the height of the tech bubble of late 2000. But today actual earnings are much higher, and analysts have proven much more sceptical about future earnings growth than during the rose-tinted tech boom.

In fact, for the past three years, corporate earnings have consistently exceeded analyst expectations. So while many investors worry that a pullback by American consumers could damage earnings growth, Blacklock argues valuations wouldnÆt look very stretched. ôWeÆre adding risk,ö he says.

Looking at historical data, he believes many stock marketsÆ real earnings yields are at or near an equilibrium. But riskier markets such as Indonesia, India and the Philippines look overvalued. ôThe market expects annual earnings growth rates of 30, 40, 50%. Is that rational?ö He says that much of the good news about these countriesÆ growth stories is priced into their stocks. ôThere isnÆt so much value there. You can own these stocks and do all right, but IÆm not confident you would make a lot of money.ö

Developed markets including the US, the United Kingdom, continental Europe and Japan appear undervalued. ôThere is now good value in the US, and if more money from Asia does invest overseas over the next six to 12 months, it is likely to go to out-of-favour markets such as the US,ö Blacklock believes.

Turning to fixed income, he thinks bond yields remain too low, with the average global 10-year sovereign bond yielding just 3.6%. Short-term rates are so low that companies can continue to borrow cheaply to finance growth. ôThey carry trade still makes sense and it will come back,ö Blacklock says. ôThe private-equity deals will return if they make sense.ö

Bond prices are high in most Asian markets, particularly TaiwanÆs where there are plenty of good companies with cash, low consumer spending and capital controls that force cash into low-yielding government bonds. ôAsia has a lot of money that it canÆt lend out, which depresses local bond yields,ö he says.

So as long as local capital remains so cheap, companies will be able to keep investing and growing. ThereÆs a possibility that real interest rates will rise to match the rate of global GDP growth, but the gap is enormous.

Prudential Asset Management is buying investment-grade corporate credit in the US. Blacklock believes the current media clamour for aggressive interest-rate cuts by the Federal Reserve to be unwarranted, and doubts the Fed will cave in. ôThe US economy is in good shape and the Fed doesnÆt want to be seen bailing out the financial markets,ö he argues. ôThe US corporate debt burden is the lowest in 30 years, so companies do not need lower interest rates.ö

His portfolios have not, however, returned to high yield, which remains expensive. ôThe gap between current and historical spreads is not big, but it just feels too early to me,ö he says.

The biggest risk to his outlook? ôIf investors stay in love with the Asia growth story.ö Then Asian stocks will enjoy continued support and may out-perform markets in the US, regardless of fundamental value.
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