Mellon Capital’s investment strategies are based on relative valuations reverting to their fair levels. As a result, our investment process and this outlook present comparisons of one asset class or market relative to another. Valuations can move away from fair due to cycles of investor sentiment, and due to local investors moving individual markets away from their fair global value. When we observe these misvaluations, we position our portfolios to capture the returns that result when valuations revert back to fair value.

Today, we do not observe a dominant economic theme driving the markets away from fundamental valuation. As a result, our portfolios hold a very well-diversified basket of tactical bets. They are diversified across both asset classes and countries.

In most of the developed market countries around the world, we still find stocks cheap relative to bonds. However, the longstanding undervaluation of stocks relative to bonds seems to be unwinding. With the run-up in equity markets, and the increase in interest rates, the relative misvaluations are significantly smaller than those we saw six months ago. As a result, we have significantly reduced our overweight position of stocks relative to bonds.

In implementing our global strategies, we make our country allocation on a currency-hedged basis. For the context of this article, presenting our views from an unhedged point of view may be more appropriate. With that in mind, inside the Eurozone, we would continue to overweight Spain. In the rest of the developed markets we would overweight Australia and underweight Japan. We find the Spanish market attractive because it is trading at a similar multiple to the rest of continental Europe, but the earnings of Spanish stocks are growing significantly faster. Australia has a higher-than-average

expected return because it has an above average dividend yield and payout ratio, but trades at an earnings multiple that is similar to the rest of the developed markets. The Japanese market is expensive because the earnings growth rate is not high enough to offset the high price of the market.

While the level of nominal interest rates on German government bonds is not higher than the rest of the world, we like Bunds because of the large term premium. It suggests that the expected reward for bearing the risks of holding 10-year bonds in Germany is larger than in the other developed markets. Given that inflation expectations and risks are similar in Germany to those of the other markets, we expect the term premia to converge. When that happens, German bonds should outperform. We find the opposite situation in Canada. The term premium is quite narrow, while at best, inflation expectations and inflation risks are in line with the rest of the world.

Our currency views are based on profiting from the carry trade as well as taking advantage of currency movements caused by capital flows and trade flows. We continue to favour the US dollar. Short-term interest rates in the US are above average, so we expect to make money on the carry trade. In addition, we expect the above average interest rates in the US to cause capital to flow into the country, supporting the dollar. There are other countries around the globe with interest rates as high or higher than the US, but most of their currencies are relatively expensive. We are short the Japanese yen and Swiss franc. Those countries have the lowest interest rates, both in nominal and real terms. As a result, owners of those currencies will lose money on the carry. From a fundamental point of view, there is not any reason to believe that the currencies will appreciate enough to offset the carry. As a result of the low interest rates, these countries will continue to be sources of capital. In addition, the currencies are not cheap enough for the misvaluations to have a significant impact on trade flows.