Risk premiums in phase 3
Recovery momentum in markets has faded in the last couple of weeks. The policy support will be there for a long time but investors have to now decide whether risk premiums are sufficient for the uncertainties ahead and the return characteristics of different asset classes. Credit could perform quite well over the coming months. That will mean lower corporate bond yields. That in turn means that the equity risk premium looks, superficially at least, quite attractive. It should, there are lots of risks. Most of these are derived from the complexities of exiting lock-down and understanding the economic consequences of that. Ultimately, growth will return, and equity returns will surpass those from credit, but be patient.
On the face of it, April was a pretty good month for investors in equities and credit with strong returns for the major indices and corporate bond markets. Yet the pure monthly return data tells us very little. The backdrop remains difficult with only limited progress towards lifting lock-downs in the major economies and the pandemic still infecting a large number of people on a daily basis. The first half of the month was very much still the relief rally, fuelled by policy actions that continued to be announced across the world. Since around the middle of April, however, returns have flattened out and in credit markets spreads have stabilised after narrowing quickly in the initial phase of the market recovery. With hindsight we can describe the evolution of risk asset performance over the last couple of months as being comprised of three phases. The first was the initial slide in asset prices following 19 February reflecting the realisation that the virus was spreading quickly outside of China. Liquidity dried up, markets became disorderly and losses mounted. The second phase was the recovery from 23 March onwards. Markets rallied, liquidity improved, and spreads narrowed. Now I think we have moved into a third phase, one in which there is limited conviction on what happens next. Playing around with different fonts, the letter “v” written in the Segoe Script font illustrates the path of equities and credit indices recently, as such - A v-shaped market evolution over February to April.
This phase is challenging for investors. The “central bank put” is still in place, effectively putting a floor under markets and making it difficult to re-visit, let alone drop below the March equity markets lows and move above the credit spread wides. But the easy recovery money has been made and momentum has certainly faded in the last couple of weeks. There are lots of questions along the lines of “why are stocks rallying when the economy is collapsing” but looking at markets with this kind of mindset somehow misses the point. First, stocks are not rallying as aggressively as they were a few weeks ago. Second, the rally has been driven primarily by the policy stimulus, without which there would be an unthinkable economic disaster. It is important to take into account that firms are still able to get finance and help in paying workers and that the income of furloughed or unemployment people is being supported to some extent. Third, a 4-6% contraction in GDP in Q1 should not be a surprise to anyone. This week the US, France and Spain released preliminary data confirming this. We should all brace ourselves for Q2 numbers being a whole lot worse. Fourth, not every corporate is a bad news story, some companies and sectors have actually seen increased demand during the crisis. Fifth, equity markets are forward looking and will anticipate recovery and perhaps some catalyst to a more optimistic future, such as a break-through in vaccine and anti-viral drug research. Yet the point is that we are not seeing euphoria – as I write the FTSE-100 is down 1.9% on the day – and the economic damage is not being ignored. But there are always going to be investors that see value.
As noted, credit spreads have stabilised. The generic spread on the European CDS “crossover” index has been trading around the 500 basis points (bps) level since the middle of April after reaching 700 bps in March and being at just over 200 bps before the crisis started. Total returns have gravitated towards zero in recent trading days. The momentum of the credit recovery has certainly faded even if sentiment in the market has improved, as indicated by the continued ability of governments and corporates to issue new paper. The most eye-catching this week was the $25bn raised by Boeing. If there is one sector that has been hit by the coronavirus crisis it is the airline industry yet the company (which had its credit rating cut in April) was able to raise the money at a spread that was significantly lower than the initial price talk suggested. But I think that it is where we are in credit now. Spreads are at levels that have only been wider in the global financial crisis when credit availability disappeared. Given where government bond yields are, the 3% yield on the US investment grade index looks relatively attractive. Fundamentals are mixed but generally worse than they were given that leverage has increased (revenue lower and debt higher) and the business outlook for many companies is clouded. Yet these are extremely low yields for companies to borrow at and, together with the support offered by government and central banks, there is the opportunity to support cash-flows until the economy opens up again. If nothing changes for a while, excess returns from credit should be positive but I am not sure that credit spreads can narrow that much in the short-term given how strong the recovery has been already and the level of uncertainty that remains in the outlook.
The new equilibrium in markets is that core government bond yields will remain low and stable. The Fed and the ECB may not explicitly follow the Bank of Japan’s example of “yield curve control” but effectively they are doing the same thing and are prepared to expand their balance sheets to keep long-term bond yields low. For the ECB that is a tougher job because it is trying to control multiple-yield curves and its policy might be better described as “yield and credit curve control”. At any rate, the ECB needs to keep peripheral spreads low so that the likes of Spain and Italy do not implode. This success of this remains a political issue. The lesson from Japan since it launched “YCC” is low volatility in government bond markets and returns that generally average zero. The new equilibrium in credit is wider spreads than before the crisis reflecting worse fundamentals, but an attractiveness to investors based on better relative valuations to the risk-free curve and support from the huge credit facilities in place. Obviously, as we move down the credit spectrum, the fundamentals get worse, but the spread attraction gets better.
Over the next year the prospective returns to credit are reasonably attractive, under the optimistic scenario of the pandemic fading out and economic activity coming back. A return to pre-crisis spreads over the next year in US investment grade would target a total return of about 10% from here. For the European credit market, the same would be around 6% and the UK, between 9% and 10%. This is the super-optimistic case as in reality it may take longer for spreads to narrow and there will be downgrades and defaults that will chip away at total returns in credit markets. Note, however, the returns from the US credit market in 2009 were 19.8% in investment grade and 57% in high yield. The economic shock this time around is worse, but the credit support from expanded deficits and central bank reserves is bigger.
I don’t need to repeat that the earnings outlook is dire. The Bloomberg estimate for the S&P average earnings per share outcome for 2020 is $130, compared to just over $160 in 2019. There is every chance the actual number for this year will be lower. At any rate, against the current index level, the market is trading at 22.4x earnings. The inverse of that is an earnings yield of 4.46% compared to the yield on the corporate bond index of 3.0%. This is not totally pure but that gives an equity risk premium of just about 1.5%, which is kind of in the middle of the range for the measure over the last ten years and relatively high over a longer time period. Of course, bond yields are repressed by central bank intervention and that has boosted the equity risk premium. But we live in a relative game. There is more reward for taking equity risk and that is right. The policy framework has reduced the credit risk premium but that has to be at the expense of returns to investors. We are not at that new equilibrium quite yet then, I guess, as market credit risk premiums are still quite high. With some kind of yield control in place for the foreseeable future, credit spreads will come down as investors search for yield and realise that the authorities have taken out credit risk from the market. Credit might be the best bet for the next year, but that will increase in the equity risk premium even more and the longer-term bet has to be on growth and stocks. Obviously, there might be better entry points as the outlook for the next few months is highly uncertain.
Getting out is harder than getting in
There is lots to ponder about how we emerge from lock-down. It’s not likely to be all sunny meadows I’m afraid Mr Prime Minister Johnson. Social distancing and a high level of focus on health will remain features of our lives for some time to come. This will slow the return to office work, limit the speed at which schools are fully re-opened, and disappoint those looking for an early return to eating out, going to the pub or taking a flight. Sectors that have been worst hit by the crisis tend to be relatively small outright components of GDP, but they are labour intensive, and the knock-on effects are widespread – both economically and socially. The high street, family businesses, sole traders, and the hospitality and travel sectors have been decimated and this will be the longer-term economic impact of the crisis. Hopefully, what can be done at the macro level will in the end benefit these parts of the economy to. The media focus is on the smaller components of the economy because that is where the social cost is the highest. But it is important to get the macro right and so far, the authorities have done a lot. That is where equity markets are focussed. But it doesn’t mean that they won’t suffer bouts of disappointment too. I have a feeling that while “sell in May and go away” might not be the right phrase, “range-trading” could very well be. We should all realise that, like QE, getting into a lock-down is a lot easier than getting out.
Dance with me
As long-term readers will know; my two passions are football and music. Lock-down and the internet has enabled some indulgence in music, and I have put together a couple of Spotify playlists (search Iggoman). Unfortunately, watching old football games on You Tube or MUFC.TV doesn’t quite have the same effect. Oh well, at least it’s still 20-18.