7th September 2016
Tom Becket, chief investment officer at Psigma considers the challenges facing bond markets (and equities too)
Last Tuesday I unleashed the latest Psigma Monthly Market Outlook upon our investment managers, investment associates and sales directors. The basic point that I made was that we live in a world of stretched valuations; bonds look expensive and equities, on the whole, aren’t much better. As investors, we are being forced to work harder and harder to eke out returns for our clients and obvious avenues for reward are difficult to locate and, if you find them, challenging to navigate.
Fortunately, there are some investments we are still very enthusiastic about, however I want to focus on the negative side, which centres on valuations and the outlook for corporate profits growth.
Let me start by stressing that I am not always of a miserable disposition, regardless of what my wife might suggest. At times in the last twelve years of investing there have been periods when the opportunities for investment were so abundant that even the perennial Grinches amongst us had to be joyful at the prospects for investment returns. 2004, 2009, late 2011 and, for a short period, early 2016 were all such times.
Now I gaze at core bond markets and my heart is heavy. As the table below shows, bond markets are fast becoming an investment desert; yield is as scarce as water and the Oases that we have found over the last few years are under heavy pressure from a wave of desperate yield seekers. How things have changed in the last decade!
To use a graphic example of how the world of an investor has been impacted, take the ten-year UK Gilt. After the recent raft of monetary madness unleashed by the MPC, ten-year UK Gilt yields have hit 0.65% (we actually unloaded some a few weeks ago when the yield hit 0.5%). Let’s assume that all investment managers charge their clients 1% and that the average annual inflation rate will be 2% over the next ten years. The “real” or inflation-adjusted return of the UK ten-year Gilt will be -2.35% annualised.
It is hard to recommend that to a client and worryingly we are fast approaching the point where it is not just government bonds offering such miserable outcomes, but also huge swathes of the corporate credit universe too. With the Bank of England committed to buying plenty of bonds in the next few months and the European Central Bank likely to extend their own bond-buying programme at this week’s latest meeting, it seems likely that the desertification of the bond market is set to spread.
Of course, the situation detailed above explains in no small part the recent success of global equity markets. The fact that companies can borrow at ever cheaper rates is fuelling a flood of bond issuance and companies are using their cheap loans to buy back their shares and keep dividends attractive. The yield differential between equity and debt is of course extremely attractive and has helped push up valuations across equity markets. At the same time, debt levels are pushing ever higher, but this is considered an irrelevance to most analysts, given how cheap debt is.
But at some point, this dynamic will change and interest rates, especially those in the US, will be critical to any turn in the strong positive correlation relationship between bonds and equities. Some are openly questioning whether the US Fed might upset the apple cart in the coming months. Our latest view is that the US will do a “one and one only” rate hike in 2016, most probably in December. At the same time, they will almost certainly guide the market lower with regard to future rate hikes, thereby reinforcing investors’ passion for dividend stocks and equities, in general.
So why can’t I just embrace the much-loved motto of “don’t worry, be happy? The major issue I have is that valuations are unattractive based upon the likely path of corporate profitability over the next eighteen months. The only real guide to future returns that has been historically proven to be prophetic to future returns has been starting valuations that you paid for an investment. Here the omens aren’t great. Focussing on the UK once again, the combined forecast data that I have seen for FTSE 100 earnings growth next year is c17%, following two years of falling earnings (analysts characteristically forecast earnings growth in both years). If 17% is delivered then one can argue that UK equities are probably about the right price (c15xs earnings) and the Bulls would highlight the 4% dividend yield.
However, our view is that the expectations are once again far too optimistic. In the classic film Wall Street, Gordon Gekko was wrong to only direct his sarcasm at US equity fund managers, who he suggested were repeatedly unable to beat the S&P 500 because they were “sheep and sheep get slaughtered”. He should have included equity analysts whose forecasts nearly always miss the target by some distance. I have always encouraged our Investment Team to use equity analyst research with scepticism; the aim of the contrarian investor should be to try and identify what others are missing, rather than simply follow the rest of the flock. To get to the 17% expected growth for UK FTSE 100 corporate profits one has to assume an oil price at $60 (possible, but far from certain in our view), persistent weakness in sterling (likewise) and broad-based margin growth. Our expectations are for earnings growth of UK and global companies to be mid-single digits percentages, which would put the UK FTSE 100 on >16xs P/E. In any other historical example, this would be considered expensive and hence our caution.
The simple conclusions that we will be discussing in the next month are that just because bonds are ludicrously expensive does not make equities cheap. It is our view that both core bond and equity markets are expensive; investors need to think outside of the box as to how they will meet their clients’ aspirations. Realistically, the traditional blend of government bonds and equities is ill-equipped to survive the years ahead, based upon starting valuations. Fortunately, we feel strongly that we have solutions to address the issues of an expensive world; hopefully that sounds less miserable than much of what I have written today.