Syz Asset Management’s Hartwig Kos explains how the US dollar is informing the fund’s allocation to Japanese and European equities, plus emerging market bonds
With a recent upgrade to the Japanese market, Europe and Japan are now our most favoured equity markets at this point. The first and most obvious reason for this is our view on the US dollar. Since the beginning of 2017, the broad US Dollar index (DXY) has depreciated by more than 10 per cent.
This move has pushed the greenback into fair-value territory on a real effective exchange-rate basis. This pronounced weakness has meant areas such as emerging-market equities, which generally benefit from a weak dollar environment, have performed very strongly over the year.
Deeply oversold dollar
On the other hand, areas which traditionally benefit from a stronger US dollar, such as Japan and Europe, have been lagging behind the broader equity universe. At this point, however, the US dollar is deeply oversold. The Fed is hinting at further interest-rate hikes and some progress appears to have been made regarding US tax reform, all of which indicates there is potential for a medium-term trend reversal for the dollar, taking the lid off European and Japanese equities. This is also supported by the fact that political uncertainty, at least in Europe, is not a factor that could unhinge market sentiment.
Both Europe and Japan continue to look cheap relative to US equities. Our equity risk premium (ERP) has indicated this relative preference for quite a few months now, and the relative cheapness can be found in many mainstream valuation metrics as well. Europe and Japan currently trade on a 12m forward price earnings ratio of 14.7 and 13.7 respectively.
This compares well to the US equity market, which is valued at 17.9. The leading price earnings ratio between the US and Europe is now at its lowest level since the end of 2012, and the differential of the leading PE ratio between Japan and the US equity market is close to its lowest level on record. Other measures, such as EV/EBITDA, also point to a pronounced valuation difference between the US and Europe and Japan.
Alternate economic realities
Moreover, the economic reality is not properly reflected in either of the equity markets. Both have been laggards despite a macroeconomic backdrop that looks even more favourable than in the US. When it comes to Europe, economic indicators across the board are as strong as they have been in the last decade. Despite the prospect of ECB tapering, financial conditions remain very accommodative to say the least. The economic backdrop in Japan has been positive too, albeit slightly more muted. Nonetheless, it is evident that the general economic environment is clearly positive for both of these markets.
EM bonds remain attractive
Bond markets continue to be expensive, as they have been for a while. Over the past few months, however, even the segments within the bond market that used to look appealing— particularly emerging markets—have somewhat lost their shine. They are still one of our top picks across the different fixed-income segments, but the weakness in the US dollar and the fact that global bond yields have drifted lower over the course of the year has meant that some valuations in this segment have started to deteriorate considerably.
As a result, different markets within the EM block have been downgraded further. Mexican hard-currency bonds are now at a mild dislike, whereas they used to be at a mild preference. Despite this clear change in intrinsic attractiveness for emerging-market bonds, the decision to maintain the overall stance in assessment is based on a relative-value argument. Emerging-market bonds still don’t look as bad as many other fixed-income segments.
Hartwig Kos is vice-CIO and co-head of multi-asset at SYZ Asset Management