It sounds odd to talk of the risk of good news, especially with some markets at or near all-time highs. Yet if we look under the surface of equities and bonds, enormous pessimism about the economy is embedded in valuations. Markets have been pushed higher by defensive growth companies. A more forceful economic recovery could cause a significant rotation within equities and bonds and spark widely divergent returns.
Below we show the European interest rate swap curve, a measure of the European risk-free rate with market expectations out 50 years into the future. We show two lines, the swap curve today and the swap curve this time last year.
What is noticeable is that the short end has actually risen a little over the last year. The ECB is unlikely to cut rates again and the market has priced this in. This is seen with short rates at an approximate floor above the current deposit rate of -50 basis points.
At the long end, however, we can see a different story. Last year, investors believed that European rates could go above zero, albeit not by much, at some point in the next 50 years. Not now. Today the entire curve out to 2070 is below zero.
There are two conclusions we can make from this. The first is that investors are acutely pessimistic about the outlook for nominal GDP in the Euro area and this is priced into assets. The second is that the discount rate for cashflows is something close to zero. This applies to European and now US assets given the sharp decline in the US yield curve. This downward movement in the risk-free rate over the last year has supported all asset prices, but those with the highest visibility of cashflows the most, namely risk-free bonds and growth stocks.
This reality may be leaving some of these assets vulnerable. In an adverse economic scenario, both markets and the economy cannot be supported by lower rates. The major source of support going forward will likely come from increased government spending and or debt monetisation. This can be powerful and lift nominal GDP, but this tide may not lift all boats.
The case for owning risk-free bonds in a balanced portfolio is becoming harder to make. Expensive Sovereign bonds will provide little upside in the event of economic weakness given rates cannot go much lower. These bonds are also acutely vulnerable to higher inflation or stronger economic growth. This asymmetry in the return profile is poor enough to make it conceivable that a sell-off is coming to expensive Sovereign debt markets soon. In this instance central banks will buy bonds to support them, but in doing so, generate more liquidity and potentially further reinforce bonds’ relative unattractiveness to other assets.
What does this mean for equities? Just as there is an asymmetry in the outlook for bonds and interest rates, there is an asymmetry in the outlook for equities and equity multiples. With such record pessimism in the growth outlook, secure growth valuations are at record highs, whilst cyclical valuations are at record lows. Anything less apocalyptic than today’s nominal growth outlook should see these two valuation extremes converge.
Given the weight of secure growth stocks in global indices, a sharp rotation out of this area into the narrower cyclical universe could drive extremely polarised returns.
For value investing this looks promising. Value stocks are largely found in cyclical businesses today, and as the interest rate curve shows, there is immense pessimism about the economic cycle. Bad news is already priced in. The likely incremental change from here is either that today’s pessimism is correct, which is largely reflected in cyclical valuations, or that the reality will be better, driving upside.
For secure growth equities the outlook appears poor. The asymmetry in the risk profile is similar to that found in rates and Sovereign bonds. Bad news is expected and priced in, and so the premium for secure growth is at an all-time high. This leaves an asymmetric set up for the multiples of growth stocks. Better economic momentum could see growth companies’ PE multiples compress.
Below we show one of our favourite charts for 2020. It shows the premium for MSCI Europe Growth over MSCI Europe Value in price to sales and price to book terms. This chart ties in with the interest rate curve above. It is another illustration of the deep pessimism about the outlook for nominal GDP. As we have discussed, the outlook has driven the premium for Growth stocks and the discount for Value stocks to a record.
The risk to markets and valuations may not be bad news but good news. Secure growth assets have been propelling markets higher and are overvalued. The narrower the growth outlook, the higher the premium these companies have deserved. But if economic momentum broadens and deepens, this premium is not justified. Given the extremes in valuation divergence the snap back has the potential to be sharp.
A value bias can hedge investors against this risk. Many European value stocks trade at historically low valuations, with high free cash flow yields and strong balance sheets. We remain optimistic about the absolute and relative returns for the LF Lightman European fund for the rest of the year.
Sources: Bloomberg, Goldman Sachs, Lightman
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