Chris Iggo, CIO Core Investments at AXA Investment Managers
Markets reflect balance of risks
To some extent concerns about some of the weaker scenarios are present in markets today. The outlook is not binary. It is not simply a case of “return to pre-COVID-19 conditions” or “descend into a prolonged global depression”. Even when we consider the progress of the virus the news are mixed. Developed economies seem to be past the worst levels of infection and virus-related deaths, but emerging economies are seeing huge increases in both. Removing social distancing restrictions is not happening uniformly but it is good news that countries are moving in that direction. However, it won’t be if the “R” number starts to go up again as social contact increases.
It is good that governments have used fiscal resources to support the incomes of workers furloughed during the crisis, but it won’t be good if few of those workers are able to return to their previous jobs because their employers have downsized or gone bust. Calling market levels against this backdrop of mixed news is not easy and market averages, as I argued last week, don’t tell the whole story. There are winners and losers and market pricing reflects that. Look at high yield, for example. In the US the market average spread against the government yield curve is 716 basis points which is roughly half way between the pre-crisis low in spreads and the height of the crisis wides. Double-B rated issuers, which make up just over half the market, have spreads that are slightly more than half-way back to their pre-crisis levels, yet CCC-rated bonds have only re-traced by 25%. That bucket represents 11% of the entire market value but is currently contributing 26% of the market spread.
High yield to perform
Peak credits may be skewing the market yield but the point is that valuations have not fully recovered and probably shouldn’t before there is more clarity on what happens to default rates, as well as the broader macro outlook. Some of the cash being generated by QE could eventually find its way into high yield but it won’t be the first port of call for most investors. Yet I believe it will still be a strongly performing asset class over the next year. Since March 23rd, the total return from the ICE-BAML US high yield index has been 16%.
Choose your macro view, choose your stock index
What about the stock market? As I said last week, there is a perception that equity markets have rallied too much given the economic outlook and the lack of guidance on earnings. Looking at the S&P500 with a price-earnings ratio of 20x and standing just 13% below its all-time high might not sit well with those investors focussed on rising unemployment and depressed consumer and investment spending. However, one can choose an equity exposure that reflects different types of economic outlook. There is enough variation between indices themselves to allow that. According to Bloomberg, the current price-earnings ratio of the equally-weighted version of the S&P500 is just 15x. The composition of the Nasdaq lends itself to a very different economic outlook to that the S&P Value index, which has a current dividend yield of 3.2% and a PE of 15x. There is no easy answer to the question of what equity indices are at the right level given the economic outlook.
I would argue that, as an asset class, I would rather hold a basket of US equities that had companies at the forefront of trends like digitalisation and innovation in healthcare, than a basket of European equities with a large exposure to a challenged financial sector. The Euro Stoxx index is much cheaper than the S&P500 on most metrics and there are reasons for that. For any investor, the appropriate thing to think about is what contribution to the overall level of the portfolio’s volatility coming from equities is optimal given the investment objectives and time horizon. That might, at times, be zero. However, when some positive exposure is required it might be worth considering this. During the last ten years, the US market has contributed lower volatility and higher total returns than the European market.
