“While US equity valuations remain elevated, international markets present compelling opportunities for diversification”

Macro

US equity valuations have reached relatively high levels as the S&P 500 forward P/E ratio hit 21x by the end of March 2024. Optimistic growth projections of 11% and 13% for 2024 and 2025 EPS respectively, however, may seem to justify these valuations. Regardless, investors should exercise caution regarding its potential impact on long-term average returns and consider diversification as a prudent strategy.

International equities present a contrasting scenario with the PE ratio for ACWI ex US standing at 13.7x and lower in comparison to the S&P 500. This discrepancy, coupled with a discount of slightly under -2 standard deviation versus US, therefore highlights an increasingly compelling case for diversifying into international equities.

Specifically, MSCI Japan has risen 16.22% YTD driven by favorable conditions for investment. MSCI Europe has also similarly risen by 6.95% YTD, following our earlier GRANOLAS call in February. Notably, peak MSCI EAFE outperformance relative to MSCI USA was observed in April 2023, with the former outperforming the latter on total cumulative returns by -6% over the last 2.3 years. Should this outperformance trend persist for the next 12 months, it could indicate a potential regime shift by April 2024 as investors rebalance their portfolios away from the US starting in Q2. Factors contributing to this shift include historically high S&P 500 forward P/E ratios correlating with lower 5-year annualised returns, corporate reforms in Japan unlocking shareholder value, and the relative attractiveness of European large-cap quality stocks.

Research by Bridgewater Associates further highlights Japan as the most significant opportunity for diversification outside of China, boasting a diversification score of 93%. Similarly, India offers attractive diversification benefits, albeit with a lower diversification score of 79%, attributed to its smaller market size compared to Japan. Conversely, while Europe possesses the largest market outside of the US, it exhibits the lowest diversification score due to its high linkage to US conditions.

In conclusion, while US equity valuations remain elevated, international markets present compelling opportunities for diversification, particularly in Japan and India. Investors should consider recalibrating their portfolios to capitalise on these opportunities while being mindful of associated risks.

Fixed Income Strategy

Markets are pricing ~65 bp of Fed rate cuts in 2024, compared to the 75 bp signalled by the median estimate of projections at the March FOMC. At first glance, this suggests room for yields to decline, but note that US Treasury 10-year yields are still 50 bp lower than their 4Q23 peak. Concurrently, a risk from tighter BoJ policy will be if long-end JGB yields rise much more significantly than they have to date, which would create more domestic alternatives to buying foreign fixed income assets. Meanwhile, the Federal Reserve will reassess whether the neutral policy rate is still as low as 2-2.5% assumed and as the dot plot implies. The short-run neutral rate could be higher still because the fiscal deficit is much larger than usual, broad financial conditions have not tightened commensurately with the rise in the funds rate, limiting transmission to the economy, and import tariffs that presumptive Republican nominee Trump plans to impose are expected to increase consumer inflation. We are inclined to shorten duration of bond portfolios.

US 10-Year Yield Still Well Below 4Q23 Peak

Source: Bloomberg Finance L.P.

Notwithstanding the BoJ’s termination of negative interest rate and yield curve control policies, credit quality amongst Japanese corporates remains solid. Recent years have seen the ratio of credit rating upgrades far exceeding that of rating downgrades, with very few corporate bond defaults. This is attributable to 1) Abenomics and relaxed financial regulations, 2) low interest rates and 3) weaker JPY. Despite the changes to monetary policies, higher rates and this spring’s negotiated wage increases being the largest since 1993, expect that that the negative impact on corporate credit quality should be quite small. Amongst financial companies, most are expected to benefit from rises in Japan bond yields. Japan life insurance companies generally have longer duration on their liabilities than on their assets, and hence rising JGB yields should have a net positive impact on their financial performance. For banks, higher rates help improve net interest margin, and as duration on large Japanese banks’ JGB holding are relatively short, any unrealized losses from JGB holdings due to rising yields should be manageable.

In Hong Kong, the recent lifting of real estate duties and more relaxed financing rules are expected to help boost Hong Kong residential property activity from relatively low levels. The Hong Kong property market is probably transitioning from a low-price, low-activity period to one characterized by low-price and normalizing activity within an environment of negative price action to clear unsold inventory over the course of 2024, before moving into a period of sustainable price improvement from 2025 onwards, albeit with upside risks post Budget FY24 measures. Furthermore, the Hong Kong retail outlook is less negative with the cyclical recovery of inbound tourist spending, and office take-up has returned to positive in 2H23, which is expected to slow the pace of decline in office rentals. Major developers have lowered dividends during their latest results to conserve cash with some disposing assets to increase liquidity and reduce debt. We look to position in Hong Kong property developers.