Investors should be making preparations for the looming possibility of an inflection point in the polar valuation extremes of both bond and equity markets. Many investors have warned that bond and equity market valuations cannot both be right, but we feel current pricing reflects a barbell between the simultaneous possibilities of growth and deflation, as if on a narrow path between a rock and a hard place.
While the timing of such an inflection can never be certain, we believe the impending rise in yield curves (and/or policy rates) will burst some of the bubbles that have clearly developed over the period.
We too believe that much of the bond market and segments of the stock market have become significantly overvalued, as money has chased income assets in a low-growth uncertain world. This saturation of capital flows to the income space – compounded by a growth in multi-asset investing – has overcrowded the traditional correlation benefits between bonds and equities.
Given the price of all assets are related to the risk free-rate, we do not believe equities will be entirely unscathed in the event of an interest rate or yield curve induced sell-off in the bond market. Fixed income assets, particularly longer-duration bonds, have enjoyed a rally sustained for almost a whole generation by the monetarist crusade against inflation. As the market resets long-term interest rates, it is not inconceivable to see much of the yield curve or credit market re-price by 10-20%, as 10 year yields normalise towards 3% or 4%. We were almost there a year ago, so it is not as unlikely as valuations and capital flows currently indicate.
So how might investors prepare for these circumstances? A potentially volatile environment requires a steady ship to weather the storm. Perhaps now is the time to batten down and take in a couple of reefs on the mainsail, rather than reach out for too much performance. The relentless drive towards benchmarking and short term performance measurement makes it ever more difficult to make provision for such adversities.
National Champions
We believe one of the ‘least worst’ places to be in this context, and the timing has been so difficult in recent years, could be invested in well-established and diversified global and national champions, the market leaders in their industries. These companies tend to provide resilience whatever the market throws at them.
The workhorses of the global economy, these are the kind of companies we should expect to be able to continue paying steady if modest dividends and servicing debts, while also consistently clipping earnings growth of around 10% – our equity holdings are trading on 18 X forward earnings, and with consensus research estimates of 9% earnings growth they seem relatively unprovocative to us just now, especially when compared to some of the traditional higher dividend payers and more defensive companies offering less growth and trading on multiples over 20 X, in the utilities sector for example where we have been taking profits more recently. Reckitt Benckiser in the UK, Swiss flavourings and fragrances manufacturer Givaudan and US group CVS Health are some examples of long-term holdings where we have confidence in their growth stories.
Our bond investments share similarly cautious characteristics. We hold bonds in quality companies issued at some very interesting, albeit junior, levels of the capital structure. These pay attractive credit spreads, but are effectively hedged to short duration. Short duration is absolutely where we need to be in the bond market right now. There are also some interesting opportunities to get exposure to floating rates of interest, as a further protection if yields continue to rise in the medium term. Our bond investments are also typically in industry-leading companies or where there are high barriers to entry – such as General Electric, Orange, or DONG Energy.
Despite our guarded view, there are still reasons to be cautiously optimistic about certain equity markets. We are relatively optimistic about US growth and believe it should still be the locomotive for the global economy.
Should this scenario materialise and we move from ‘survival’ mode to a full-blown ‘business cycle’, this is the moment of greatest risk – as yields rise, risk appetite returns, consumption grows and business invests. While all welcome developments, this will be the crucial inflection point when risk must be more realistically priced once again.
