24th January 2016 by Chris Iggo
Another week of falling markets and oil prices. But there were some signs of stability towards Friday. Perhaps valuations have moved enough to be more in line with economic fundamentals. Quantitative easing (QE) inflated financial markets, but didn’t inflate economies by anywhere nearly enough to justify high equity prices and thin credit spreads. Now that the monetary policy tools have been mostly used up there isn’t scope for big policy signals to re-start the bull market. Don’t look to fiscal policy either as no government is going to be announcing tax cuts or spending increases anytime soon. What delivers recovery then? It may be just flows. It may be that investors start to see valuation outweighing negative sentiment and a realisation that the reality of the macro outlook is that “disappointing” growth is the new norm. But it is still growth. Short duration bond portfolios that yield 7% should not be ignored in such an environment.
Buy-time? – Financial assets have got cheaper this year. Equity markets have dropped by 10% or so and some are 20% or more below their peak of last April. Credit spreads are wider making corporate and financial bonds much cheaper relative to government bonds and, in parts of the market, much cheaper in absolute terms. In the US high yield market the value of the total return index is back to the low it reached in mid-2013 when markets were hit by the “taper-tantrum”, and in spread and yield terms we are back at levels seen at the height of the European peripheral debt crisis in 2011. Even in the investment grade market there has been a relative cheapening of credit. The Euro BBB index has seen its generic spread widen by almost a 100bps over the last year and by 27bps this month alone. Stocks, credit, high yield and emerging market bonds are all a lot cheaper since the New Year. Is it time to start buying?
Disconnected – We sometimes forget some of the bigger themes. One that has been discussed in this blog a few times in recent years is the impact that QE had on financial asset prices. It is arguable whether QE had a positive direct impact on economic activity or inflation – although we can’t know the counterfactual of course – but it is clear that the expansion of central bank balance sheets did have a profound impact on financial asset prices. Quantitative easing was the most direct form of forward guidance as it took out the term premium from interest rate markets on the premise that it would be many years before interest rates returned to the kind of levels that prevailed before the crisis. At the same time financial market participants substituted riskier assets for extremely low yielding government bonds and the general decline in credit costs allowed equity valuations to rise. Not everyone might agree with the QE argument, but if you do, an explanation for what has been happening to markets in recent months might be that valuations are re-adjusting to a level that is more consistent with the macroeconomic fundamentals of low growth and inflation and significant uncertainty about the global business cycle. The market value of the S&P500 rose by 2.5x between the beginning of 2009 and end-2015 while US nominal GDP only went up by 25% over the same period. In terms of the ratio of the stock market capitalisation to GDP, 2015 did not quite see the US reach the levels of the tech boom at the end of the 1990s, but apart from then it was higher than at any other time. This is not a very fashionable measure of valuation but a more widely used one that also tells a story of high valuation levels. The ratio of stock prices to estimates of forward earnings was above 17x in early 2015 – again not as high as the valuations seen in the late 1990s but the highest levels since valuations bottomed out in 2008. The discussion is not just limited to equities. Bonds have been in a bull market in recent years delivering returns in 2010-2012 and 2014 that were significantly above the long term return expectations for fixed income, driven by aggressive reductions in official interest rates, falling inflationary expectations and central bank buying.
Post-crisis growth struggles – If valuations become out of line with long term macroeconomic fundamentals there are two aspects to the narrative today. The first is pay back for that period of richness, the second is the growing realisation that global growth is hampered by the legacy of the financial crisis (debt) and by us having reached the limits of traditional macroeconomic policy making. Interest rates are close to zero and even the Federal Reserve (Fed) may struggle in the short term to carry on with its process of normalisation, while fiscal policy is constrained by high debt-GDP ratios in most developed countries and by much tighter credit costs in developing economies. Watching interviews from the great and the good gathered in Davos this week, I don’t see much optimism for the growth outlook and especially on the factors that are mostly in focus – China and the oil price. The slowdown in China and the collapse in commodity prices cuts revenues for those countries and companies that sell to China or rely on high global prices for basic materials. This means reduced earnings and concerns about the ability to service debt. The big risks for the next two years is a hard landing in China and a recession in the United States. Thankfully, in our view, the risks of those two things happening is low – but there is a risk.
Need somebody – Nevertheless, the growth outlook is subdued and will remain subdued because of the debt drag, deflationary pressures and the lack of any source of major stimulus. What this means for equities is that more realistic earnings expectations will have to be incorporated into valuation calculations, but price-earnings ratios are very quickly moving to discount lower earnings growth. The S&P was trading above 17x and is now just a smidge above 15x on the basis of current earnings forecasts for the next 12 months. UK, European and Japanese markets have fallen quickly in the last few months. For the credit markets, continued low interest rates and steady growth is actually a very supportive environment and valuations are so much more attractive than they were. For European markets the focus is again on the European Central Bank (ECB) providing some additional stimulus in March, following Mario Draghi’s comments this week. This means, as we already know, a long period of very low rates and improving financing conditions in Europe which is supportive for corporate balance sheets and credit. A word of note, however, on the ECB. The bounce in markets at the end of the week was explained by a positive reaction to Draghi but it was only six weeks ago that the ECB cut the deposit rate and extended the QE programme – that did not provide any permanent support for equity markets. Additional efforts might, but only if the valuation and macro outlook at the time are improved. At least we should expect that Draghi is not going to do anything that makes sentiment permanently worse.
Supply and demand – There are some big calls to be made in fixed income markets this year. At the asset allocation level the big decisions will be focussed on the potential for a turnaround in high yield and emerging market debt, while at the more micro level the opportunities will be to look for a recovery in currently distressed sectors and individual issuers. These are mostly related to oil and gas, mining and metals and basic materials. Part of this requires going back to the macro view. A continued expansion in the US, even at a subdued pace of 2.0%-2.5%, is good for credit. A stabilisation of perceptions about Chinese growth and policy making will help emerging markets more generally. I discussed the China story this week with colleagues from our research and equity teams and the shared view was that the longer term trend is towards lower GDP growth rates as the Chinese economy shifts towards lower trend productivity growth and a gradual but manageable depreciation of the currency over time. But there are risks that foreign investors continue to be more concerned about growth and more concerned about the Chinese government’s ability to present credible policy. Where there was less confidence was on oil and commodities. I looked at the global oil supply and demand situation. Over the last couple of years there has been the biggest accumulation of excess supply relative to oil demand for a very long time. Changes in relative supply and demand are well correlated with the global oil price and any recovery in prices really needs for either demand to charge higher (it needs to get colder) or supply to be reduced. What is the source of the supply glut? It is Saudi Arabia pumping at almost full capacity, it is the reluctance of US shale producers to cut back output aggressively and it is the prospect of Iranian supply coming back on to world markets. It does not bode well for oil prices in the near term nor for oil companies. Just as I am writing this note, Moody’s has announced widespread rating downgrades to energy companies which will do little for investor confidence in those credits. The reality is that the outlook for oil prices is intrinsically determined by national geopolitical strategies and the particular intentions of Saudi Arabia relative to Iran and the global shale market. Who knows what to predict there?
Cushions – Still, there are value opportunities in credit markets with spreads being at 3-year highs across the different sectors. We can’t rule out a further widening of spreads if sentiment towards the global economy deteriorates further, but we would say at this stage that conditions seem right for an outperformance of credit relative to risk-free assets over the next year. The cushion of extra yield for credit investors above what is available in government bonds means that spreads could widen by another 25bps in European investment grade, 30bps in the US and well above 150bps in high yield for before a credit portfolio underperforms an equivalent government bond exposure. These break-even levels are not out of reach of course, and spreads have been much higher at times in the past, but we don’t see a 2008 type financial crisis nor any aggressive monetary shocks. The clear danger for credit markets is defaults in either the emerging sovereign space or in the energy or commodity sector and this risk will remain with us for some time until there is some better news from global commodity prices. All the more reason to be very disciplined about the individual credit names that one holds in a portfolio and to have a strong view on those businesses and their ability to repay their debt.
Yield relative to duration – The more cautious approach for those who generally still like credit but want a lower risk exposure is through short duration strategies focusing on bonds in the 1-5 year part of the market. In Europe this part of the market is very low yielding but at least it is positive, which can’t be said for cash products. In the US and sterling, the short end of the credit market yields almost 2.5%. In the sub-investment grade markets a short duration portfolio in high yield and emerging markets can easily be in the 6%-7% range. Buying bonds with yields well above the duration is a tried and trusted approach in fixed income investing and the divergence in valuations between the richest and cheapest parts of the market is as wide as it has been for a very long time. As I’ve said before, QE has delivered negative yields in the highest quality parts of the bond market, investor sentiment and risk aversion has now delivered high yields in the rest of the market. The opportunity is now there to add credit risk. There may not be any kind of signal that generates flows out of low or negative yielding assets into risk, but the valuation differences alone may slowly encourage these adjustments to portfolios. Remember last March, hard on the heels of Draghi announcing QE the bund market suddenly went into meltdown taking yields from 8bps at the 10-year to 80bps. Markets do sometimes display some mean-reversion and given the moves of recent weeks a rally in stocks, credit, high yield and, even oil, can’t be ruled out.