More Volatility on U.S. Horizon Has Sights Turning to Asia

Stocks Steady Down, for the Moment

After weeks of struggling, global equities stabilized last week. In the U.S., the S&P 500 Index rose 2.08% to 1,961, the Dow Jones Industrial Average climbed 2.05% to 16,433, and the tech-heavy Nasdaq Composite Index advanced an even stronger 2.97% to end the week at 4,822. Meanwhile, the yield on the 10-year Treasury rose from 2.13% to 2.19%, as its price correspondingly fell.

While investors caught a bit of a breather last week, volatility remains elevated. And although the bumpy ride is expected to continue, creating challenges for investors, we also see opportunities. In particular, Asian equities, both in Japan and emerging markets (EMs), look attractive right now relative to other regions.

U.S. Stocks Still Pricey

For the most part, stock and credit markets advanced last week. Encouragingly, the rally in stocks was led by more cyclically sensitive sectors, such as transportation, banks and semiconductors. Credit markets also stabilized, with the spread between the yields of high yield bonds and 10-year U.S. Treasuries now roughly 50 basis points (0.50%) tighter than just a few weeks ago, implying more investor appetite for risk.

Both stocks and bonds are benefiting from relative stability in overseas markets as well as some easing of China fears. Still, volatility remains elevated. Looking at realized returns over the past month, annualized volatility on the S&P 500 Index is above 30%, triple the level from early August. We expect this pattern to continue given the persistence of several factors: a shift in the credit environment, a pending interest rate hike by the Federal Reserve (Fed) and expensive stock valuations.

On the latter, while large-cap U.S. equity multiples are now 7% below their February peak, valuations remain above the long-term average. This is problematic given the pending shift in U.S. monetary policy. Quantitative easing is gone, and while this week’s Fed decision remains a coin flip (will the Fed raise rates or not?), there is no question that U.S. monetary policy is at an inflection point.

Even if the Fed demurs until later in the year, short-term rates are climbing. Last week, two-year Treasury yields traded to just below 0.75%, a high for the year. Without the tailwind of easier money, U.S. equities will need to get by on earnings growth, of which there hasn’t been much of late, rather than monetary policy-induced multiple expansion.

Opportunities in Asia

The outlook for U.S. stocks may be muted, but we do see opportunities in other parts of the world, particularly in Asia.

Last week, Japanese stocks enjoyed their biggest one-day advance since 2008. Investors were encouraged by Prime Minister Abe’s pledge to further lower the corporate tax rate. Although implementation of the so-called “third arrow” of reforms has been mixed, Japanese corporate profitability continues to improve. The return-on-equity (ROE) for TOPIX stocks was 8.6% in August, up roughly a half point from a year ago. As such, we remain constructive on Japanese equities.

We also see opportunities in Asia’s emerging markets, despite our more cautious stance on the EM asset class more broadly. Many of these markets have sold off in concert with China, leaving valuations once again cheap, including the Chinese H-Share market listed in Hong Kong.

In addition, with most countries running a current account surplus and possessing sizeable foreign currency reserves, we see EM Asia as better positioned to withstand a Fed tightening cycle than other emerging markets. This dynamic has been evident in the relative resilience of EM currencies, an important determinant of overall return for dollar-based investors. With a few notable exceptions, namely Malaysia and Indonesia, most EM Asian currencies are holding up relatively well against the dollar. Even in China, despite all the hand wringing over the recent devaluation, the yuan is down less than 3% against the dollar this year. In contrast, currencies in Russia, Colombia, Turkey and Brazil have plunged.

Finally, many investors assume that commodities and EM go hand-in-hand. In fact, most of the countries in Asia, including China and India, are large commodities importers. They benefit when commodities prices decline. Contrast that with the situation in places like Brazil, a large exporter of raw materials, where last week Standard & Poor’s downgraded Brazil’s sovereign rating back to junk status. Admittedly, other factors—notably a major political scandal and deteriorating fiscal picture—also played a part.

For all of these reasons, we favor opportunities in Asia, both in Japan and in the region’s emerging markets.

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