La richesse tout autour
Investor sentiment currently reflects the good economic news and the technical behaviour of markets. Interest rates are seen as manageable and the risk radar is not bleeping very loudly. Rich valuations, while not being ignored, are not seen themselves as reason to sell. Yet adding money in some parts of the market today does not look that attractive. Credit markets, in general, are expensive and the upside to returns is very limited. Technical factors might support fixed income markets still, but the macro play continues to favour equity returns.
Investors have enjoyed unprecedented returns over the last year and a half. Since March 2020, the annualised price performance of the S&P 500 equity index has been 52%. For the NASDAQ, it has been 70% and for the EuroStoxx, the annualised equivalent price return has been 40%. These compare with long-term (since the 1980s) annualised price returns of 9.1%, 11.1% and 4.7% respectively. For fixed income, the story was interrupted by the rise in yields in Q4 2020 and Q1 2021. Yet even here we see total returns of 4.5% from US investment grade credit since February 2020, 11.7% from high yield and 5.3% from global inflation linked bonds. These returns are above recent historical averages.
Macro and technicals remain positive
Our recent quarterly review of markets concluded that returns continue to be driven by a positive macro environment and by very strong technical factors which, in fixed income markets at least, explain why yields have fallen back over the last three months and why credit spreads have continued to tighten. The increased volume of central bank balance sheet buying since the onset of the pandemic has increasingly taken government bonds out of the market and driven yields down, leading investors to take on more credit risk to get higher yields. In the US, as I have mentioned before, domestic banks have been major buyers of Treasuries in response to the growth in their deposit base. Even in equity markets, there has been a technical influence on returns – largely that the surge in global money supply has found its way into equities through savings products.
But valuations are a concern
This has delivered markets to an uncomfortable place in my view. The macro story is unlikely to get much better – strong growth with transitory inflation, still accommodative monetary conditions, net fiscal stimulus in many economies and this all translating to healthy balance sheets in the corporate and household sectors. As much as the macro outlook is seen as a positive in our assessment of risky assets, valuations are seen as rich. This is particularly the case in credit markets which currently see spreads at their lowest levels since the global financial crisis. Not only are spreads narrow at the market level. They are compressed within markets between credit ratings buckets. The spread between the US high yield BB-rated index and the CCC- rated index stands at 369 basis points (bps) – a record low according to the Bank of America/ICE bond index data. The average for that spread since the index was first published a decade ago has been 680 bps and in March 2020 it was over 1200 bps. It’s the same story in investment grade credit markets. In Europe, 30% of the universe has a negative yield and over half the universe has a spread relative to the swap curve of less than 100 bps. There is not much dispersion in credit markets, which means alpha generating opportunities are limited.
Earnings supporting equities
The debate on valuation is more nuanced in equities. Price-earnings ratios have actually remained quite stable based on consensus forward earnings expectations. The US’s S&P 500 index trades with a multiple of 21 times 12-month forward earnings. This translates into an earnings yield of 4.8%, which is attractive relative to a risk-free bond yield of 1.46%. It is also more attractive than the index yield of 2% for investment grade corporate bonds in the US. But even here we are probably basing these metrics on an earnings outlook that is unlikely to get much better. The consensus has earnings growth peaking this year, before settling down to 11.8% in 2022 and 10.8% in 2023. These are still healthy corporate earnings growth numbers but are clearly subject to changes in the outlook for inflation, rates, growth or the pandemic. Having said that, there is some wiggle room. The current consensus for S&P earnings in 2023 is $230 per share, which puts the market today on an 18.7 multiple of that number today. That’s a 5.4% earnings yield. The obvious risk is that those 2023 earnings per share numbers get revised down as a result of a change in the outlook.
Given these valuation concerns across markets, it is difficult to answer the question about what investors should do with their portfolios today and how any spare cash should be invested. When we consider the positive macro and the technical drivers of expected market performance, and the more negative valuation aspect, the glue that holds all that together is sentiment. Investors have cash, see an ongoing recovery and are bullish. What can burst the bubble? The obvious thing is rates and inflation but that will only manifest itself if a central bank turns decisively hawkish. Related to that, the beginning of bond tapering could be a negative signal. A massive technical force behind market performance has been the creation of liquidity by central banks. If – sorry, when – they, led by the Federal Reserve, start to reduce that flow, markets may respond negatively. Other negatives could come from disappointments on earnings especially as it appears that positive guidance ahead of Q2 reporting season has picked-up. References to supply shortages, production bottlenecks and pressure on margins in earnings reports will be heavily scrutinised. In Europe, attention will start to turn to the political cycle which is likely to have a backdrop of debate over fiscal policy.
Market timing is impossible. It’s hard to hedge against adverse market moves because they are unknown. Option strategies in equities could work but the risk is you pay for the insurance and it expires before the event. I think there is an argument for looking at relatively cheap hedges in credit markets using credit-default swaps which are at their lowest generic price levels for some time. As regular readers will know, I am a fan of having some bond duration in portfolios just in case risk sells off. The correlation between bond and equity returns, over the long-term, is negative. Yet recently it has been positive. That could correct by equity returns remaining positive and bonds selling off, or equities correcting lower and bonds rallying. In the former, the negative return from bonds is not likely to be greater than the positive from stocks, while in the latter, a rally in bonds in a risk-off scenario would dampen the losses from equities to some extent. If investors want to remain with some exposure to higher yield in bond markets, then short-duration strategies limit the sensitivity to any increase in rates.
Goldilocks might hang around
In short, I think the argument for caution – at least with new investments – is worth considering. Markets are priced for the continuation of a scenario that could not be better constructed. Investors are living with risks that are seen to be manageable while growth and the technical set-up of our financial system is rewarding capital allocated to risk. They are also sitting on handsome returns. Of course, it could continue like this. Credit spreads were even narrower before the financial crisis. Equity valuations could get higher if exuberance really takes hold. Real yields could stay negative for a while until the increased borrowing from governments – a lot of which will be directed to financing the energy transition – really starts to kick in. Global savings are high and have been boosted by the pandemic so it might take government and corporate deficits to widen even more before the cost of capital really moves. That is not a story for this summer. But really, a lot of the credit markets don’t offer much and the cost of underweighting credit at this stage is fairly low. Volatility is unlikely to stay this low indefinitely.
Talking of exuberance, I am taking a couple of weeks off work and fully expect England to be acclaimed as European champions by the time I write my next note. No other team has had such a friendly draw and been able to play the majority of games at its home stadium. That surely made a difference against Germany. Ukraine and either Denmark or the Czech Republic stand between England and a showdown with – most probably – Belgium or Italy. It’s got to be on hasn’t it? English enthusiasm does have a tendency to run away with itself and I just have to think of the word “Iceland” to introduce some doubt. Anyway, here’s hoping.
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