Something for every view
The future is always unpredictable but when the recent past has been so strange the outlook is even more clouded. That makes investment decision making hard and trying to assess whether markets are at fair value is impossible. Given the range of investible assets and indices, one could argue that there are prices that reflect most economic outcomes. Comparing aggregated economic data against aggregated market level pricing is just one way of managing asset allocation decisions. Another is to weigh the drivers of return and risk against the valuation of asset classes in the context of building portfolios that try to achieve an objective over a certain time horizon. Today, policy, recovery dynamics, potential drug developments and opportunities provided by changing preferences are the key reasons to be positive. That does not mean we should ignore the risk of a second wave, prolonged weak growth and geopolitical issues.
Support for markets from central banks and governments remains impressive. This week France and Germany proposed a €500bn Recovery Fund that would represent a significant step towards fiscal mutualisation in the Euro Area. We must wait to see the Recovery Fund’s final form but the idea that the distribution of the fund’s resources will be based on need while the allocation of the repayment burden will be based on ability (GDP), is one that breaks some taboos in Europe. The proposal was met positively in the markets. It could reduce pressure on the ECB to be the main policy support for the region and coming a week after the German Constitutional Court ruling, the announcement of the Recovery Fund was very good news for Italy and Spain. Grants from the fund will complement the already stretched fiscal resources in those countries, taking some pressure off spreads. There could also be some positive multiplier effects once the money gets used. Perhaps most importantly it raises the prospect of further fiscal mutualisation in the future. However, markets want to see the final details and agreement amongst all EU member states. Only then will spreads move even lower. There is clearly huge political weight behind the proposal but small fiscally conservative states within the Euro Area have something of a record of being spoilers. If it were to fail, then there would be no choice but for the ECB to massively increase its QE envelope to prevent a catastrophic widening of spreads.
Strong central bank support
Globally the support from policy has allowed risky assets to continue to perform. Since the S&P low on March 23rd, equity and credit markets have posted returns that can’t be ascribed solely to valuation arguments or expectations of ultimate economy recovery. They have been mostly policy driven. Central banks are creating bank reserves and buying government bond and corporate bond assets from the market. The cash created ultimately purchases other assets or supports income and spending, which in turn should be reflected in asset prices. There is a rising tide and the strength of the “forward guidance” means that investors are comfortable buying assets with valuations that would perhaps be seen as too rich given the circumstances. The US Federal Reserve’s holding of Treasury securities has increased by just shy of $2trn compared to a year ago. That’s $2trn more bank reserves (base money) – equivalent to almost 10% of GDP. The total assets of the US commercial bank sector have risen by $2.6trn already this year (15%) compared to just $794bn in the whole of 2019. On the other side of the balance sheet, customer deposits have risen by $1.9trn this year – this is money in the bank accounts of firms, households and other entities.
More to come?
Policy makers seem to be consistently searching for ways to reassure markets that there is still more that can be done. Jerome Powell hinted that US fiscal policy could do more. Andrew Bailey (Bank of England) did not rule out the use of negative interest rates in the UK. I note above the European Recovery Fund. While this is good we have to remember the reason they are keeping the policy plates spinning is because we face the worst economic situation for many, many decades. And that brings us back to the question that we all should be pondering – are markets focussing too much on the policy and not enough on the economic growth outlook? What is the risk of growth being so weak that the outlook for corporate revenues and thus for equity and credit valuations, is so bad that investors would prefer to hold cash than suffer a portfolio drawdowns? Right now, I err on the more optimistic side. We know that policy is supportive because it is here and now and it is dynamically impacting markets. We don’t know what GDP growth will be in Q3 or 2021. Most forecasts are for some form of recovery and early indications from countries and states that are lifting social distancing restrictions are in line with such forecasts. That’s not to say the medium term outlook is great given the potential for longer lasting damage done to supply chains, employment and capacity. The reluctance of some central bankers to definitely rule out the use of negative interest rates tells us that there are future scenarios under which the economy and markets would be so weak that tools to dissuade households and companies from holding cash would be needed. We are not at that point today.
Markets reflect balance of risks
To some extent concerns about some of the weaker scenarios are present in markets today. The outlook is not binary. It is not simply a case of “return to pre-COVID-19 conditions” or “descend into a prolonged global depression”. Even when we consider the progress of the virus the news is mixed. Developed economies seem to be past the worst levels of infection and virus-related deaths, but emerging economies are seeing huge increases in both. Removing social distancing restrictions is not happening uniformly but it is good news that countries are moving in that direction. However, it won’t be if the “R” number starts to go up again as social contact increases. It is good that governments have used fiscal resources to support the incomes of workers furloughed during the crisis, but it won’t be good if few of those workers are able to return to their previous jobs because their employers have downsized or gone bust. Calling market levels against this backdrop of mixed news is not easy and market averages, as I argued last week, don’t tell the whole story. There are winners and losers and market pricing reflects that. Look at high yield, for example. In the US the market average spread against the government yield curve is 716 basis points which is roughly half way between the pre-crisis low in spreads and the height of the crisis wides. Double-B rated issuers, which make up just over half the market, have spreads that are slightly more than half-way back to their pre-crisis levels, yet CCC-rated bonds have only re-traced by 25%. That bucket represents 11% of the entire market value but is currently contributing 26% of the market spread.
High yield to perform
Weak credits may be skewing the market yield but the point is that valuations have not fully recovered and probably shouldn’t before there is more clarity on what happens to default rates as well as the broader macro outlook. Some of the cash being generated by QE could eventually find its way into high yield but it won’t be the first port of call for most investors. Yet I believe it will still be a strongly performing asset class over the next year. Since March 23rd, the total return from the ICE-BAML US high yield index has been 16%.
Choose you macro view, choose your stock index
What about the stock market? As I said last week there is a perception that equity markets have rallied too much given the economic outlook and the lack of guidance on earnings. Looking at the S&P500 with a price-earnings ratio of 20x and standing just 13% below its all-time high might not sit well with those investors focussed on rising unemployment and depressed consumer and investment spending. However, one can choose an equity exposure that reflects different types of economic outlook. There is enough variation between indices themselves to allow that. According to Bloomberg, the current price-earnings ratio of the equally-weighted version of the S&P500 is just 15x. The composition of the Nasdaq lends itself to a very different economic outlook to that the S&P Value index, which has a current dividend yield of 3.2% and a PE of 15x. There is no easy answer to the question of what equity indices are at the right level given the economic outlook. I would argue that, as an asset class, I would rather hold a basket of US equities that had companies at the forefront of trends like digitalisation and innovation in healthcare, than a basket of European equities with a large exposure to a challenged financial sector. The Euro Stoxx index is much cheaper than the S&P500 on most metrics and there are reasons for that. For any investor, the appropriate thing to think about is what contribution to the overall level of the portfolio’s volatility coming from equities is optimal given the investment objectives and time horizon. That might, at times, be zero. However, when some positive exposure is required it might be worth considering this. During the last ten years, the US market has contributed lower volatility and higher total returns than the European market.
Pros and cons
I am not one for market timing. I like to look at the contribution of different asset classes to the investment objective and then assess what is the best way to get exposure to that asset class based on overall macro views (or, indeed, to not have any exposure). It is hard to say whether you should buy equities today or not. But if the time horizon is long enough and the consideration of the drivers of return over time are considered enough, then some exposure to equity markets is warranted. The checklist for markets right now is: policy is positive; the slowing of infection rates in developed markets is positive; the evidence that activity is recovering in those areas where restrictions are being lifted is positive; and that there continues to be some level of optimism around the development of a vaccine, testing and remedies. Add to that opportunities created by changing business and consumer preferences (which, in my opinion, explain the continued strong performance of stocks like Amazon, Facebook, Netflix and Apple). The negatives are the sheer scale of some of the economic numbers (UK retail sales down 15% in April, for example); the ongoing lack of clarity on the earnings outlook from many companies; the uncertainty about the future behaviour of the pandemic (risk of secondary spikes) and concerns about how quickly growth can recover. In addition, existential issues in the EU and the ramping up of US-China concerns also have the potential to undermine investor sentiment.
Yields and duration
Having balance is key. Bond yields are very low but having some duration exposure for portfolio diversification can still be achieved. Inflation linked bonds, for example, have more duration at every maturity level than conventional bonds. The UK is a good example. The duration of the 10-year plus conventional gilt index is 19.7 years and the index-linked index is 22.9 years. That’s an additional 30bps of performance for every 10bps move lower in yields for linkers relative to gilts. Some readers might ask why one would contemplate buying gilts when just this week a new gilt was issued with a yield-to-maturity that was negative. Fair point. I would say that yield does not necessarily equal return and there is still scope for the gilt market to produce total returns that are above current yield levels (curve flattens, more of the curve goes into negative yield territory). Of course, investors buy gilts and other government bonds for a host of reasons. Capital preservation being one of them and with the Bank of England buying, the risk to capital remains very low. (See more on this subject in my piece on LinkedIn here)
The Fed, not China, counts for Treasuries
Finally, a little observation. It seems clear that the US-China relationship continues to deteriorate. Over the years there has been a concern that China could reduce its holdings of US Treasuries, creating problems for the bond market and leading to higher yields and a weaker dollar. In reality, China’s holding as a share of the total outstanding amount of US debt peaked about a decade ago and has slowly fallen to around 5%. At the same time, and especially in recent years, the Fed’s share has increased, to around 15% today. The US’s trade deficit with China has come down because of reduced imports and its reliance on China for financing that deficit is much less today. The geo-political situation between the US and China may get worse but selling US Treasuries against that would be the wrong thing to do.
Stay safe and #StayAtHome