Summer is time for vacation, and getting ready for a trip has become almost a ritual for me: pack bags for my large family, load the car, don’t forget the GPS and check weather conditions. The last two points, I believe, apply not only to planning a safe and comfortable personal trip, but also to navigating the financial markets.
The financial “weather” seems nice: volatility is extremely low across almost all asset classes, as a consequence of the extra-loose monetary policy. However, as with the weather, we are aware that financial conditions can rapidly change. History suggests that periods of exceptionally low volatility should be treated with skepticism, as they have usually preceded vicious market turmoil.
Our “GPS” for navigating market conditions (valuations) is pointing out that some areas of the financial markets are getting stretched. Core government bonds, credit markets and U.S. equities are the most likely candidates for a bubble.
Starting with bonds, there is a lot of debate in the market as to whether economic growth (and consequently interest rates) will remain lower than historical norms for the next decade and beyond. However, we cannot be sure that this will be the case (we will know only ex-post) and, for this reason, we believe it’s not wise to build an investment strategy around this view. Moreover, as the economist Andrew Smithers pointed out in a recent FT.com piece, there seems to be no evidence of a strong empirical long-term relationship between growth (either U.S. growth or global growth) and the U.S. real interest rate.
Even if interest rates “in equilibrium” should be lower, we still see a role for monetary policy in influencing short-term economic cycles. Monetary policy can also be used for other purposes: recently, in its Annual Report, the Bank for International Settlements made a call for tightening monetary policy, by invoking the risk of “euphoric capital markets” and instability.
Given that economic conditions are improving in the U.S., we are convinced that the current level of real interest rates is cyclically too low. Consequently, we expect a mean reversion of interest rates towards more normal levels, as discussed in Be Aware of New Normal: The Economic Cycle Is Not Dead. This is not a healthy outlook for core government bonds, where yields continue to lie towards the bottom of their historical range.
Meanwhile, credit market valuations are becoming less and less attractive for investors. Spread compression has continued across the whole ratings spectrum. Corporate default rates are artificially low: companies that in the past would have struggled to access the credit market are able to raise money for refinancing. The hunt for yield induced by central banks’ zero interest rate policies has pushed the share of credit assets in household portfolios (as a percentage of total credit outstanding) to unprecedented levels. Meanwhile, liquidity in the trading market is fading.
Both investment-grade and high-yield credit retain some appeal in comparison with core government bonds. However, the upside potential is very limited, while overheating is rising. Therefore credit markets, in our view, need to be handled carefully.
Turning to equities, our valuation models based on Cyclically Adjusted Price Earnings (CAPE) – which help us decide optimal allocations among asset classes – indicate that Europe and some Emerging Markets (China) remain the most interesting investment opportunities. U.S. equity markets appear less compelling according to our valuation metrics, cash flow and by profits.
To check U.S. equity valuations, we have also considered Tobin’s q indicator (the ratio of overall market value against the replacement cost of corporate assets): the chart below indicates that the U.S. equity market is getting overvalued, as the current level of the q ratio is significantly above its historical average (the light blue line).
Meanwhile, U.S. non-financial corporate cash flow as a percentage of GDP is at historic highs. So far, companies have channeled this cash into accelerating buybacks of their own shares and into M&A activity, rather than into fixed capital investments. This cash flow has been a welcome source of demand for equities that has helped to buoy markets, but has not resulted in a strong stimulus to the real economy, a necessary condition, we believe, for healthy future profitability.
Lastly, if we consider corporate profits, they are at their highest level ever relative to GDP. Our forecasts suggest that, assuming real GDP growth of around 2-2.5% (as a proxy for sales growth), the potential for further profit growth is limited, as margins (net income/sales) are becoming unsustainable. This risk of future earnings growth disappointments could pose a threat for the continuation of the rally.
All three metrics confirm our cautious view on U.S. equities. Currently, we see this market as presenting the clearest risks of overheating. At the same time, we appreciate that in case of a correction, other equity markets would also be affected.
So, what’s next for our investment strategy? Based on our main scenario, we believe that improvements in the global economy and the ongoing financial repression from central banks should continue to be mildly supportive for risky assets. With the lower and lower returns we expect for all the main asset classes, we have already implemented a more defensive approach, reducing the size of our investment decisions without changing their direction.
But our directional stance on risky assets could also change, subject to developments in our main scenario or a major unexpected event (a so-called “unknown unknown”). Regarding the former point, the base scenario of multiple transitions in the principal economic arenas is so far confirmed, as we see U.S. economic momentum strengthening, Europe (slowly) returning back to growth and emerging markets engineering slowdowns to engender more balanced growth.
With respect to the latter point (unknown unknown), it is unpredictable by definition. As such, we prefer to focus on hedging what we believe are the main risks: deflation in Europe and an abrupt change in U.S. monetary policy (i.e. a policy mistake). At the same time, facing tighter financial market conditions, it’s important to continue to monitor valuations closely, in order to see when the “odds” with respect to our stance become less favorable.
More than ever, we believe that now is the time to keep our GPS switched on.
For a PDF version of Giordano’s latest CIO Letter, click here.