Over the last few years, U.S. equity valuations have increased significantly.
In fact, since 2011, the average price-to-earnings ratio of the market has risen from 13.5 to 17.5 on a forward earnings basis, says Jean-Baptiste Nadal, managing director and lead portfolio manager at Metropolitan West Capital Management in Los Angeles.
But, “this level of valuation appears to be fair, if not slightly overvalued, for the short-term, based on historical averages,” he adds. That means people don’t yet need to adopt defensive approaches when it comes to investing south of the border.
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Nadal explains, “U.S. companies are in good shape, [and] the economy is growing at a controlled pace with no sign of recession in sight. Plus, interest rates are low and are expected to remain low, while the dollar is strong and is likely to remain so for the medium term.”
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Yet, domestic market volatility will jump as the Federal Reserve looks at hiking interest rates. Investors can use volatility to their advantage, says Nadal, but it may also push people to make “some marginal portfolio adjustments away from U.S. equity markets, especially since there are new [global] opportunities starting to emerge.”
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Where to invest globally
Monetary policy decisions made around the world will also draw investment away from North America, Nadal predicts.
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In particular, “the BoJ and ECB are likely to [continue to] extend their balance sheets through quantitative easing,” he adds. “So, while geographic diversification hasn’t worked for the past two or three years, it may be time for investors to increase exposure to regions of the world that have [previously] disappointed, such as Europe and emerging markets […] Despite investors’ frustrations, diversification isn’t dead.”
Currently, “Europe is the region of the world that generates the most skepticism,” says Nadal. “But Europe has the means to address its structural issues, and it’s likely to surprise on the upside.”
Read: What European QE means for portfolios
In emerging markets, “long-term fundamentals remain strong. These are driven by demographics, improving infrastructure and rising GDP per capita.”
In fact, Nadal finds international markets could generate better returns than the U.S. in the short term. “Valuations appear very attractive for non-U.S. equity markets.” That’s partially because, in the next few years, “the U.S. market will be consolidating its formidable gains of the last five years.”
Why clients need to adjust return expectations
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Domestic bond yields to remain low