Why the case for lowering overall equity risk is getting stronger
Erik Knutzen (pictured) is chief investment officer, multi-assets at Neuberger Berman.
The asset allocation committee went slightly underweight US equities this quarter, as valuations look increasingly stretched and bond yields edge upwards. Another weak earnings season could trigger volatility, and bond yields may be too low to provide much in the way of diversification or a tactical cushion.
While some value remains in European equities, commodities and emerging markets, the case for lowering overall equity risk is getting stronger.
On 11 August all three of the main large-cap US equity indices reached new record highs. It was the first time this had happened on the same day since 1999, and an appropriate time to “raise the bar,” midway through the first week of the Rio Olympics.
The markets have not been performing like narrow specialists, either, but more like decathlon all-rounders: This summer saw bond yields pushing ever lower as equities vaulted ever higher. The limitations of the human body mean that one day we may get an Olympics where no records are broken.
Similarly, economic fundamentals in theory put a limit on how much “faster, higher and stronger” financial markets can go, as the Latin of the Olympic motto puts it. At Rio, 27 new world records were set. In markets, the asset allocation committee thinks the limit may be closer.
The committee has held an underweight view on investment-grade bonds for some time. This quarter, they were joined by all flavours of the US equity market, albeit in the category of “slightly underweight.”
To be clear, this was a marginal decision, and US equities still look attractive relative to the return outlook from government bonds—but it is the first time in this unusually long cycle that the committee’s view on this asset class has fallen below neutral.
What concerns committee members are valuations. When we look at non-US developed world equities, which we maintained as a slight overweight, we see tailwinds from accommodative monetary policy, improving earnings and compelling relative value between earnings and dividend yields and exceptionally low core government bond yields.
In the US, the case is less clear. The issue is not that current multiples are too high in themselves—a 17 times forward price-to-earnings ratio is in line with historical averages—but that the earnings growth required to satisfy them seems optimistic in the current environment.
Our view that we are still in the middle of the business cycle had helped us exploit the panic-stricken sell-off at the beginning of 2016, but that now it was “crunch time” for earnings growth as markets start to “lose patience” with the ongoing profits recession.
S&P 500 earnings per share look set to come in at around $118 – $120. A year ago the expectation was for something more like $125 – $130, which is now the projection for 2017 among even the more bullish analysts.
That would represent less than half the growth required to make sense of today’s 17 times forward earnings valuation, leaving us with a multiple somewhere closer to 21 times, which would begin to look stretched. The current Q3 earnings season is shaping up to be one of the most important in two years.
Of course one must take into account the unusual amount of—as it were—artificial performance enhancement going on in the form of quantitative easing and low interest rates. The recent hawkish tone from some Federal Reserve Open Market Committee members is probably designed to prevent undue inflation of financial asset values, but it only serves to balance the Fed’s dovish actions in delaying its second rate hike, not to mention the increasingly aggressive stances of the Bank of Japan, the Bank of England and the European Central Bank.
This helps make sense of the apparent anomaly of ever lower bond yields paired with ever higher equity markets. Those yields provide the discount rates with which we value future cash flows, and the lower they go, the more expensive equities look given the same level of expected earnings.
In other words, some of the multiple expansion we have seen so far is attributable to lower bond yields rather than higher earnings forecasts, which, along with the ever-shortening list of sensible alternatives, helps explain why equity markets have so far been patient with earnings disappointments.