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High US Stock Valuations May Bruise Economic Sweet Spot

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A combination of economic growth, low inflation and easy monetary policy in developed economies is currently supporting a range of asset classes, including equities, corporate credit, real assets and government bonds, according to investment strategists at Russell Investments.

The strategists note, however, that this market environment is asymmetrical, as the downside potential outweighs the upside, especially in U.S. equities, where the cyclically adjusted price-to-earnings ratio of the S&P 500 index is near its most expensive level ever except for 1929 and the late 1990s.

They remain underweight U.S. equities and prefer Europe, Japan and emerging markets. They also consider government bonds expensive across regions and expect global yields to trend upward over the coming year.

(Related: New Strategy to Navigate Market Volitility, Sept. 21 webcast with Michael Finke)

“Global growth, inflation and monetary policy have created an economic sweet spot as we look ahead to the fourth quarter of 2017, but we believe high valuations make U.S. equities vulnerable to any news that upsets the industry consensus on moderate growth, low inflation and low interest rates,” Russell Investments’ global head of investment strategy Andrew Pease said in a statement.

“With the potential for volatility to return, we believe a globally diversified multi-asset investment strategy may offer the best opportunity for both portfolio returns and downside protection.”

The strategists caution that U.S. fixed income markets may be underestimating potential upward pressure on interest rates in 2018. Contrary to the industry consensus, Paul Eitelman, a multi-asset investment strategist for North America, thinks the Federal Reserve will remain on hold in December, but expects it to be more aggressive next year.

The strategists also think that U.S. economic fundamentals still look mediocre. They see “secondhand growth” from other economies as likely helping U.S. earnings, which supports shifting equity allocations toward the international markets that have been the engine of growth and trading at more attractive valuations.

“The biggest risks to U.S. markets — a recession scare or an inflation scare — do not seem likely in the near term,” Eitelman said. “Fixed income markets appear to have currently priced in only two more hikes through the end of 2018, though we think a faster pace is warranted by fundamentals.”

Here are Russell strategists’ latest views on the eurozone, Asia/Pacific and currencies:

In Europe in the third quarter, the rising euro exchange rate neutralized strong economic growth, favorable politics and robust earnings, according to strategist Wouter Sturkenboom. In the fourth quarter, he expects the balance between these two forces to tilt back in favor of the fundamentals, supporting eurozone assets.

Expectations for eurozone GDP growth remain unchanged from the third quarter at 2%, though growth could inch slightly higher for 2017.

Equity market valuation is reasonable, in contrast to the U.S., supporting Russell Investments’ relative preference for Europe.

Graham Harman and Alex Cousley are becoming more positive on the Asia/Pacific region. They say China’s National Congress in October should provide further progress on the ticklish chore of combining structural reform and deleveraging with ongoing economic growth.

Japan’s outlook is firming, with gross domestic product surprising to the upside. Australia’s economy is improving as well. The main note of caution in the region comes from the tensions around North Korea.

Van Luu sees euro bullishness as a crowded trade that in the near term could stall the rally. He expects more euro upside in 2018, but is skeptical that the British pound’s strength can be maintained. Luu thinks the Japanese yen will remain under downward pressure.


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