Erik Knutzen (pictured) is chief investment officer, multi-assets at Neuberger Berman.
The asset allocation committee went slightly underweight US equities this quarter, as valuations look increasingly stretched and bond yields edge upwards. Another weak earnings season could trigger volatility, and bond yields may be too low to provide much in the way of diversification or a tactical cushion.
While some value remains in European equities, commodities and emerging markets, the case for lowering overall equity risk is getting stronger.
On 11 August all three of the main large-cap US equity indices reached new record highs. It was the first time this had happened on the same day since 1999, and an appropriate time to “raise the bar,” midway through the first week of the Rio Olympics.
The markets have not been performing like narrow specialists, either, but more like decathlon all-rounders: This summer saw bond yields pushing ever lower as equities vaulted ever higher. The limitations of the human body mean that one day we may get an Olympics where no records are broken.
Similarly, economic fundamentals in theory put a limit on how much “faster, higher and stronger” financial markets can go, as the Latin of the Olympic motto puts it. At Rio, 27 new world records were set. In markets, the asset allocation committee thinks the limit may be closer.
The committee has held an underweight view on investment-grade bonds for some time. This quarter, they were joined by all flavours of the US equity market, albeit in the category of “slightly underweight.”
To be clear, this was a marginal decision, and US equities still look attractive relative to the return outlook from government bonds—but it is the first time in this unusually long cycle that the committee’s view on this asset class has fallen below neutral.
What concerns committee members are valuations. When we look at non-US developed world equities, which we maintained as a slight overweight, we see tailwinds from accommodative monetary policy, improving earnings and compelling relative value between earnings and dividend yields and exceptionally low core government bond yields.
In the US, the case is less clear. The issue is not that current multiples are too high in themselves—a 17 times forward price-to-earnings ratio is in line with historical averages—but that the earnings growth required to satisfy them seems optimistic in the current environment.
Our view that we are still in the middle of the business cycle had helped us exploit the panic-stricken sell-off at the beginning of 2016, but that now it was “crunch time” for earnings growth as markets start to “lose patience” with the ongoing profits recession.
S&P 500 earnings per share look set to come in at around $118 – $120. A year ago the expectation was for something more like $125 – $130, which is now the projection for 2017 among even the more bullish analysts.
That would represent less than half the growth required to make sense of today’s 17 times forward earnings valuation, leaving us with a multiple somewhere closer to 21 times, which would begin to look stretched. The current Q3 earnings season is shaping up to be one of the most important in two years.
Of course one must take into account the unusual amount of—as it were—artificial performance enhancement going on in the form of quantitative easing and low interest rates. The recent hawkish tone from some Federal Reserve Open Market Committee members is probably designed to prevent undue inflation of financial asset values, but it only serves to balance the Fed’s dovish actions in delaying its second rate hike, not to mention the increasingly aggressive stances of the Bank of Japan, the Bank of England and the European Central Bank.
This helps make sense of the apparent anomaly of ever lower bond yields paired with ever higher equity markets. Those yields provide the discount rates with which we value future cash flows, and the lower they go, the more expensive equities look given the same level of expected earnings.
In other words, some of the multiple expansion we have seen so far is attributable to lower bond yields rather than higher earnings forecasts, which, along with the ever-shortening list of sensible alternatives, helps explain why equity markets have so far been patient with earnings disappointments.
Current multiples could be maintained should bond yields remain low. But the prospect of another earnings disappointment in an environment of rising yields makes us cautious. Yields indeed appear to be on their way up. So does the Libor rate, notwithstanding the Fed’s decision to hold off on its next rate hike.
This is a reminder that these are issues not only of valuation, but also of portfolio risk management. Like swimmers, pole-vaulters and sprinters all setting world records at the same Olympics, the positive correlation of bond and equity markets feels great on the way up. It is not very helpful on the way down, however.
In recent years, bonds have tended to perform well when investors became risk averse and equity markets declined, but this time around bond yields may already be too low for those investors to feel they offer a genuine tactical cushion.
This is something we are picking up in our quantitative tactical models, which are not only suggesting that portfolio volatility should be higher than it has been recently, but are also supportive of a slight underweight in bonds—a signal we haven’t seen for a long time and which we put down to stretched fundamentals, which can overwhelm their long-term diversification benefits. It’s also worth noting, ‘alternative yield sources’ such as income-producing equities have seen their valuations similarly inflated partly due to flows away from low and negative yields in bond markets.
Committee members agree that investors may have lost sight of just how risky these positions have now become.
In short, despite low inflation in goods and services, the world of financial assets appears to be a fully priced place. We are a long way from where we were just nine months ago, when pockets of compelling value were opening up in a lot of places. But does that mean we are in a value-free world? Our expressed views suggest not. In fact, we have more slightly overweight positions this quarter than we did last time around.
We moved from slightly overweight to neutral in high yield, but again this was a marginal decision and discussion on the committee revealed plenty of room for debate. We observed that just as a lot of the downward move through 2015 had been concentrated in the energy sector, so had much of the rebound this year. There was still room for spreads to tighten in other sectors, and even once that had happened a rotation from bonds into bank loans could still make sense, as spreads in the latter have seen much less tightening.
Against that, we acknowledged that the energy sector’s return of 25% for the first three quarters of 2016 has indeed been extraordinary, but a 15% return for the market as a whole hardly counts as a dawdle. High-yield spreads remain above their long-term averages, however, and way above the tight levels seen in 2006 – 07, which may provide long-term investors an incentive to buy on any dips.
Elsewhere, we continue to favour private debt, which offers attractive value relative to private and public equity, as well as solid fundamentals in the shape of modest leverage, conservative capital structures and low rates. We also maintained our slightly overweight position in non-US developed equity markets, held our neutral view on master limited partnerships (MLPs) despite strong recent performance, moved from neutral to overweight in commodities and emerging market equities, and consolidated our overweight in hedge funds.
Some might see contradictions here. Commodities and MLPs are a significant part of the US equity markets, which we have at slightly underweight. And it is difficult to imagine emerging markets performing well in the absence of the growth that would also support US stocks.
Once again, part of the explanation is that these are marginal views. Another is that the delayed rate hikes and weaker dollar that would likely follow a poor Q3 US earnings season could be supportive of commodity and emerging market valuations. (While we maintain an overweight in the dollar, that reflects a marginal, tactical view rather than an expectation for the sort of renewed strength that would pose a significant risk to global assets.)
Finally, it simply reflects relative valuations: some markets enjoy more of a cushion against the downside, and more room on the upside, than others.
Importantly, this suggests MLPs still have the potential to provide decent value for income- or yield-seeking investors relative to bonds and other alternative yield sources from the equity markets such as high-yielding stocks and, especially REITS, which we downgraded to slightly underweight.
While REITS still represent value relative to investment-grade bonds, they are beginning to look stretched based on their own historical multiples, and next to other real-asset income generators such as MLPs. Despite strong performance through Q2 and Q3 of this year, MLPs are still down 4% annualized over the past three years, versus a 15% annualized return from REITS.
Nonetheless, overall market valuations are undeniably high, and that makes overall market risk levels high, too. When volatility is so low and correlations so high, the environment could be primed for the sort of shock that relieves the pressure—but in doing so, generates a spike in volatility followed by a breakdown in correlations.
As the change in our view on hedge funds suggests, in this environment we believe there is a big role for long/short strategies, risk-premium strategies and other relative value approaches to investing—albeit with a lot of caution around event-driven and activist equity strategies.
These have the potential to eke out positive returns in this tightly correlated environment while offering more attractive upside than straightforward beta-oriented strategies, should volatility strike.