World financial markets resumed their steady march higher in the second quarter, buoyed by renewed optimism about the global economy and ongoing support from Central Banks, and just a dash of good Ol’ fashioned “animal spirits.”
Unlike last year, this year the rally in risk-oriented assets has been broadly based, including global stocks, bonds, commodities, precious metals and real estate.
In a world of negative real rates of return on traditionally “safe” assets such as government bonds and cash, investors are showing a growing willingness to accept higher levels of risk to achieve higher returns. Valuation levels across asset classes are elevated, especially in the credit markets.
At the same time, investors seem increasingly indifferent to traditional sources of worry such as geopolitical conflicts in Ukraine and the Middle East, and political drama in Washington. For the time being, these things do not seem to matter. Volatility levels, a good indicator of investor sentiment, are at record low levels, suggesting complacency. (Chart 1)
The global economy is improving slowly. After a difficult winter, the U.S. economy is showing renewed, albeit sub-par growth, with increasing levels of capital investment and hiring. (Chart 2) There is also a high level of deal activity as companies are now using cheap money to buy other companies, rather than just buying back their own stock. And, we have seen a robust pipeline of initial public offerings from companies in the technology and biotechnology area. Some look at this as a warning sign of a market top as insiders are rushing to the exits to cash out, and perhaps rightly so, but unlike the late 1990’s most of these companies are real businesses with real long-term potential.
We are even seeing some whiffs of inflation in the U.S. as shortages of supplies, transportation and skilled labor in certain sectors and regions drive prices higher. We do not think that inflation is a major concern just yet, but like a brush fire in dry grass, it is something that can happen quickly, catching Central Bankers and investors off guard.
Europe is also on the mend, although growth is notably slower and more feeble than in the U.S. and deflationary pressures still persist. (Chart 3) The Euro area is not nearly as vibrant and competitive as the U.S., but it has more room for improvement which can create opportunities for investment.
The developing world remains a mixed bag and it is important not to think of developing and emerging economies monolithically. Developing countries and regions tend to get lumped together into investment benchmarks and products, but are driven by important differentiating factors including government structure and rule of law, monetary policy, interest and inflation rates, infrastructure, and dependence on natural resources, to name a few.
The Chinese economy appears to be bottoming, but it is also undergoing an important transition from a rapid growth, export-driven economy to a moderate-growth, consumption-driven economy. This will take years and has important implications for investment. India, under the new leadership of Narendra Modi, is showing renewed growth and optimism.
Latin America, dominated by Brazil, appears to be stalled under the weight of ineffectual political leadership, inflation and diminished demand for exports from China. Mexico is the exception to this, benefitting from strong demand from the U.S. Africa is also experiencing a surge in growth, and has enormous potential, although it still lacks the infrastructure, institutions and rule of law that are a requisite foundation for strong and enduring growth.
Against this backdrop – specifically, sub-par global economic growth, ongoing extraordinary monetary policy, low interest rates, low volatility and rising valuation levels – questions of valuation, potential return and risk become more important than ever.
One of the most common questions we are asked by clients is “are we in a bubble?” This is a reasonable question. Since March of 2009 the U.S. stock market has almost tripled with only two corrections greater than 10% and no correction of more than 6% in almost two years.
Bonds have also produced remarkably strong returns in recent years as interest rates have sunk ever lower and investors have shown an insatiable appetite for yield without much regard for risk. Interest rate spreads between corporate bonds including high yield bonds, and U.S. Treasury Bonds are back near pre-2007 levels. (Chart 4) Similarly, interest rate spreads between former toxic sovereign bonds in Europe such as Portugal, Ireland and Spain are now selling at only a modest premium in yield to U.S. Treasury Bonds, and French and German bonds sport a lower yield than U.S. Treasuries. (Chart 5) We think U.S. Treasuries are overpriced, but they seem like a bargain relative to European bonds.
Meanwhile money is pouring into private equity and venture capital, and larger and larger deals are being announced with looser and looser financing terms, reminiscent of pre-crisis 2007. Small technology companies that didn’t exist a few years ago are being purchased for enormous valuations by larger technology companies, reminiscent of pre dot-com bust 2000.
All of this has shades of “déjà vu, all over again,” to quote Yogi Berra.
That being said, we do not think that we are in an outright bubble as much as we are seeing signs of bubbly behavior, especially in the credit markets.
Stock valuations are rich but not ridiculous. U.S. stocks are, as a whole, fully valued, but there are pockets of opportunity in out-of-favor sectors. European stocks are back in vogue and are slightly less expensive than U.S. markets, but also have more challenges to growth. Developing economy stocks - and especially Frontier economy equities – have been moving back in investor favor after being shunned last year. We think they remain attractive over the long-term but will continue to face growing pains over the short term.
Bond market valuations are a greater concern. Investors are desperately searching for yield and are showing a willingness to take on significantly greater marginal risks for significantly lower marginal returns, with a false sense of security. Money is pouring into high yield, bank loan, foreign and emerging market bond funds, with the hope of achieving a 4% to 6% annual return. That is the best case, assuming nothing goes wrong. But a meaningful rise in interest rates and/or credit spreads, both of which have much more room to rise than fall from here, or a decrease in market liquidity would likely cause prices to fall significantly. In effect, investors are taking equity-like downside risk with very limited upside potential for return. This makes no sense to us.
Our base case is that, barring some significant event from left-field, global stock markets should continue to march higher, supported by an improving economy, cheap money, and a lack of compelling alternatives.
Stock market valuation levels in the U.S. and across global equity markets are slightly elevated relative to their historical norms, but close to fair value taking the current level of interest rates into account. (Chart 6) U.S. stocks are much cheaper than they were in the late 1990’s, when there was an obvious bubble in equity valuations, and on par with where they were in 2007, prior to the credit crisis, when the bubble was in the real estate and debt markets. At current valuation levels, even acknowledging the impact of monetary policy in depressing interest rates and propping up the price of financial assets, stocks are no bargain, but neither are they in a bubble. They still represent our favorite asset class for long-term investment.
Having said that, many of the managers we use, especially in the more “defensive core” of our client portfolios are holding higher levels of cash, or have reduced their net exposure to stocks. We invest with a long-term approach, and we feel that it is important to maintain exposure to high quality, growing companies around the world, but at the margin, we don’t think this is a time to be reaching for yield or chasing after returns. The reward relative to the risk is not attractive.
We can say with near certainty that there will be a correction. We just don’t know when or why this will be. Neither does anybody else. As valuation levels rise and volatility levels fall, the financial markets become increasingly vulnerable to disappointments and unpleasant surprises. A smaller correction now would be better than a larger one later.
Expectations for earnings are quite high going into the second quarter reporting period and it remains to be seen whether corporate profit reports and guidance measure up.
We are maintaining a reduced exposure to bonds in client portfolios to serve as a “foundational base,” and are primarily invested in defensive “Total-Return” bond managers who have broad flexibility to invest throughout the global credit markets. Like everyone else, we expect interest rates to rise over time, but do not think that this rise will be immediate or significant. Interest rates will likely stay at depressed levels as long as economic growth and inflationary expectations remain muted. We don’t see any advantage in making a big bet on interest rates one way or another, or in taking much risk in bonds. We would rather take our risks in equities and with alternative managers that have a far superior potential for long-term return on investment over the coming years.
As always, we welcome your questions and comments.
Jurika, Mills & Keifer, LLC