“While some value remains in European equities, commodities and emerging markets, the case for lowering overall equity risk is getting stronger,” the Neuberger asset allocation committee said.
Neuberger’s committee thinks this a particularly convincing case with regards to US equities, an asset class they have remained neutral in throughout the unusually long cycle. By the third quarter, the committee had changed its stance to US equities to “slightly underweight.”
Although US equities still look more attractive relative to the return outlook from government bonds, which the firm has been underweight in for some time, valuations are still looking increasingly stretched, said Erik Knutzen CIO of multi-asset class portfolios.
“When we look at non-US developed world equities, which we maintained as a slight overweight, we see tailwinds from accommodative monetary policy, improving earnings and compelling relative value between earnings and dividend yields and exceptionally low core government bond yields.”
In the US, by contrast, Knutzen says “the case is less clear,” and that has a lot to do with earnings growth that appears too optimistic to be achieved in the current climate.
“S&P 500 earnings per share look set to come in at around $118 – $120. A year ago the expectation was for something more like $125 – $130, which is now the projection for 2017 among even the more bullish analysts.
“That would represent less than half the growth required to make sense of today’s 17 times forward earnings valuation, leaving us with a multiple somewhere closer to 21 times, which would begin to look stretched. The current Q3 earnings season is shaping up to be one of the most important in two years,” he added.
These stretched valuations have a lot to do with the aggressive quantitative easing measures from central banks, which are pushing bond yields to record lows and making equities appear even more expensive.
“In other words, some of the multiple expansion we have seen so far is attributable to lower bond yields rather than higher earnings forecasts, which, along with the ever-shortening list of sensible alternatives, helps explain why equity markets have so far been patient with earnings disappointments,” he argued.
While Neuberger may be seeing fewer opportunities in US equities, it has moved from neutral to overweight in commodities and emerging market equities.
This may seem contradictory as commodities make up a sizable chunk of US equity markets and growth that supports emerging markets would likely support US stocks also, Knutzen admitted. But he anticipates that the delayed rate hikes from the Federal Reserve and weaker dollar that will likely follow a poor US earnings season could be supportive of commodity and emerging market valuations.
Neuberger has also maintained its neutral stance toward master limited partnerships, publicly traded vehicles that are not liable for corporate income taxes, on the basis that it has the potential to provide decent value for income or yield-seeking investors over high-yielding stocks and REITs.
“Despite strong performance through Q2 and Q3 of this year, MLPs are still down 4% annualized over the past three years, versus a 15% annualized return from REITS,” said Knutzen.
