Market Insights: Yield is the New P/E
By: Wayne Yi, CFA
Equity markets have remained resilient so far this year, with the S&P500 index clawing back about half of its 2022 losses and the Volatility Index trending towards 2021 lows. This has been accomplished despite the country suffering a mini-banking crisis in March and government debt default concerns (which were resolved this week but chipped away at the reserve currency’s credibility), as investors focus on the light at the end of the rate-hiking tunnel, and on the better-than-expected corporate earnings through this inflationary period. After 10 hikes in 15 months, and Fed Funds at 5.25%, it looks like the financial tightening program is nearing completion, and while inflation is still high at 4.9%, the decrease from the 9% peak is welcomed.
Congress has raised the debt limit almost 80 times since 1960 (in $tn)
Source: Statista
In this period of relative calm, investors have repositioned portfolios into the laggards of last year. While the S&P500 fell about 18% in 2022, the more expensive Nasdaq Composite index was down over 30%, with Tech, Internet and Consumer sectors being notable losers, declining around 30-40%. As the fear of further rate hikes subsided, interest in these beaten down, higher valuation sectors returned. This year, the Nasdaq has more than doubled S&P500 returns, with the same Tech, Internet, and Consumer sectors leading the charge. But not everything has bounced back, particularly value-oriented sectors and smaller cap stocks. The Russell 2000 index suffered a similar sized drawdown to the large cap S&P500 in 2022, but has failed to participate in the recovery seen in the larger cap indices. There are a few factors at play here, notably investor concerns around regional banks, and the index’s undersized exposure to the recovery in Tech when compared to the larger representation of the sector within the S&P500.
However, a bigger theme to note is the general lack of breadth for stock participation in the current rally, even within the large cap space, as investors are reluctant to take on broad equity market risk beyond the largest, most defensive companies. We see this in the divergence of returns between the S&P500 index, which sizes its constituents based on market capitalization (larger companies have greater representation in the index), and the equal-weighted index (all constituents receive equal representation). Most of the largest companies in the index, Apple, Microsoft, Google, Amazon, Facebook, Nvidia, and Tesla, are up 30-160% so far this year. These 7 stocks comprise over a quarter of the capitalization-weighted index and drove a significant portion of this year’s returns, whereas they make up less than 2% in the equal-weighted index and are barely perceptible with regard to performance contribution. The result is the equal-weighted index hovering around flat thus far in 2023. The vast majority of stocks have had a much more muted return experience this year as recession risks continue to hang in the back of investors’ minds. We view this as a cautious view on markets, as a more benign environment would have favored smaller, cheaper, and more cyclically sensitive, stocks.
Year-to-date Performance of S&P500, S&P500EW, Russell2000
Source: Simon Quick Research, YCharts
The market’s anticipation for a pause and eventual fall in rates later this year is supporting higher valuations for stocks at over 18x Forward P/E for the S&P500. The collapse of Silicon Valley Bank and Signature Bank and rising alarms around real estate debt maturities within regional banks has tightened financial conditions enough to cause the Fed to consider stopping hikes within the next couple meetings. Concerns of a hawkish Fed quickly reversed in March as 2-year bonds fell more than a whole percentage point to 4% and 10-year bonds likely set the ceiling for rates in this cycle at around 4%, before falling to about 3.3% within a month. The market is now expecting the start of a rate cutting cycle at the end of this year, and continue through 2024. This is despite Chairman Powell’s comments on keeping interest rates high even if the Fed were to pause.
Net Percentage of Banks Tightening Lending Standards
Source: JPMorgan
While we expect rate cuts to begin as inflation trends lower, risks remain whether the Fed can engineer a smooth slowing of the economy and bring equilibrium to the labor market all the while maintaining capital markets stability. Or will the strain of the sudden rise in rates and tightening financial conditions result in an acceleration of corporate and real estate defaults that lead into a more substantive recession. With this backdrop, we are finding opportunities in fixed income and alternatives as attractive hedges and diversifiers today to what may be a more volatile environment for stocks in the back half of this year. We are recommending increased exposure to fixed income assets, across both high-quality liquid investments for principal protection, and high income credit opportunities to take advantage of high rates. We believe this move would de-risk investment portfolios while still generating attractive returns.
Traditional fixed income assets came under tremendous pressure last year, as the rapid rise in rates repriced bonds lower. However, this has allowed the asset class to reset to the historical relationship of being a diversifier and risk mitigant to stocks while generating modest income. Today, the Barclays Aggregate index yields around 4.5%, up from under 2% at the end of 2021. Our current liquid fixed income managers are doing better than that, yielding over 6% for investment grade credit quality portfolios. This is a compelling return given the meaningfully lower volatility profile of these assets versus stocks and the diversification benefits they provide in more challenged markets. High quality fixed income can rally in a risk-off environment as investors tend to sell stocks and buy bonds to protect their capital. Furthermore, any rate cuts from the Fed to ease financial conditions would benefit fixed income as well.
Investment Grade Fixed Income is at Pre-GFC Yields, High Yield Bonds Offering Stock-like Returns
Source: Simon Quick Research, Barclays
With the rise in interest rates, high yield credit, specifically floating rate loans, is yielding over 10% today. These assets are on the riskier end of the fixed income spectrum, but can offer equity-like returns through regular interest income distributions with still lower volatility than stocks. We are seeing interesting strategies that can complement traditional cash flow lending, such as asset based, residential, and secondaries opportunities which provide a diversified stream of consistent earnings in the face of a challenging economic outlook. We look forward to introducing these opportunities to our clients in the coming months.
ASSET ALLOCATION RECOMMENDATIONS
Equities: Under-weight
Anticipation of a Federal Reserve pivot away from its current rate hiking program has fueled an equity market rally to start the year. Despite regional bank pressures, the overall economic outlook and expectations for corporate earnings growth remain robust, supporting near 18x forward P/E multiples for the S&P500. However, we recognize that the vast majority of the returns were driven by only a handful of technology-oriented mega-cap stocks, while most constituents saw only small gains, if not losses, over the same period. We believe the broader economy is slowing as higher interest rates, and still above target inflation levels weigh on profitability and strain balance sheets. Having recovered approximately half of the index’s peak-to-trough losses over the past six months, we are now recommending lightening equity exposure into this strength for those clients who are at or above target-weightings in equities. While the economy may kick the recession can another year, valuations do not leave enough margin for error, especially as interest rates are expected to remain high. Alternatively, we recommend building out Fixed Income allocations in portfolios.
Value versus Growth: We maintain a relatively balanced approach to Value versus Growth styles, but with a slight bias to Defensive portfolios that are only modestly cheaper than their core benchmark but exhibit greater business resiliency. These managers would be more protective in a market sell-off, but lag in a market rally.
Large versus Small: We complement our Large Cap Defensive exposure with selective, active small- and mid-cap funds. Small caps tend to be more economically sensitive, so we look to be more valuation-conscious in this segment.
Domestic versus International: We maintain an overweight to Domestic stocks, based on the quality of businesses and depth of capital markets in the US. We have modestly reduced that overweighting with the addition of a Defensive International strategy. We are modestly underweight Emerging Markets.
Fixed Income: Over-weight
We would look to increase client Fixed Income allocations to Over-weight via a barbelled approach of investment grade bonds (for some income generation but to also serve as an equity market hedge) and floating rate credit (with attractive income distribution in a higher rate environment and still benign default experience) to complement and diversify away from stocks. The traditional fixed income allocation is highly liquid and can be quickly reinvested into other opportunities that may present themselves in a more challenged market. Floating rate debt exposure is currently offering equity-like return potential while moving up in capital structure seniority and reducing overall portfolio volatility versus equities.
Interest Rate Sensitivity: We had extended our duration as the Fed raised rates throughout 2022. As intermediate and long-rates have since tightened, we recommend leaning shorter duration, notably as short-dated Treasuries yield around 4% while intermediate yields less. Interest rates are a hedge to economic weakness and Fed rate cuts.
Credit Quality: We seek to maintain an overall investment grade credit quality in our liquid fixed income exposures, however would balance this positioning with illiquid direct lending and structured credit investments that exhibit strong equity-like returns despite lower volatility. We are currently limiting this high yield exposure to alternative credit strategies and private investment opportunities that are less sensitive to daily flows and mark-to-market variability.
Liquid Alternatives: Target-weight
Hedge Funds: Heightened volatility across asset classes is creating a ripe opportunity for diversified and long/short hedge funds. As traditional assets continue to remain under pressure, strategies that can take advantage of short-term pricing dislocations in a choppy market can generate more attractive returns through this challenging period.
Real Estate: We have been adding core-plus real estate opportunities, notably in residential assets for its inflation aligned properties and as a complement to stock and bond portfolios.
Illiquid Alternatives: Target-weight
Valuations are adjusting lower, following public market declines in 2022. Committed capital for opportunistic deployment over the next few years should make this vintage of fundraises highly attractive.
Secondaries and Distressed investing strategies may benefit well from a slowing economy as they tend to be opportunistic buyers of good assets at discounted valuations, during a period of market uncertainty. The next couple years may be an attractive time to be an opportunistic buyer of real estate assets that may be unsold or facing refinancing pressures.
About Wayne Yi, CFA
Wayne Yi is the Chief Investments Officer and a member of the Investment Committee for Simon Quick Advisors. He leads the firm effort on all market research and manager diligence across traditional equity and fixed income strategies as well as in alternatives, including hedge funds and private equity allocations. Prior to joining the firm, Wayne was a Co-Portfolio Manager and member of the Investment Committee for SAIL Advisors, a hedge fund investment firm headquartered in Hong Kong. He also served as the senior analyst for their Credit and Event-Driven strategies. Prior to SAIL, Wayne was the Sector Head for Credit and Event-Driven strategies at Robeco-Sage, a hedge fund investment firm based in New York. Wayne started his career in investing at Delaware Investments as a Research Analyst for high yield and investment grade bonds across various industries. He then joined Goldman Sachs’ Investment Research department, where he was the Senior Analyst covering high yield bonds in the Technology sector. Wayne is a graduate of the University of Pennsylvania, where he received a B.A. in Economics and in International Relations. Wayne is a CFA charterholder. To learn more about Wayne, connect with him on LinkedIn.