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Why Neither Equities Markets Nor Bond Markets Look Attractive

Equities at 2,800 on the S&P 500 are not attractive relative to their risk. That gives a fwd-12-mos (FTM) earnings yield of 608bps versus a US 10-year of 300bps. 

The earnings picture is bullish while the rates and liquidity picture is bearish.

Focus on Liquidity, Not Value

Stocks valuations don’t look bad at about 16x FTM earnings. Paying 16x for earnings is right around “fair value.” But value is a measure of risk, not where something will go.

We know that S&P earnings are likely to increase by about 10% in 2019 to around 177. At 16x, this would price the S&P a bit above the 2,800 mark. An easing in back-end rates would be, for the time being, required to push it up toward 3,000. That mark is unlikely in the near-term, though another expected 9%-10% earnings growth in 2020 with a steady rates environment would put 3,000 on the table toward the end of next year.

The operative question on equities is whether the rise in profits will be sufficient to offset the rise in rates.

How do you determine this?

You look at:

(1) what central banks are likely to do with their own interest rate measures, which has implications for the pricing of debt globally, and

(2) for rates further out on the curve, how much debt is coming on the market, who are the potential buyers of that debt and what is their ability to buy it.

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2019 Bond Supply and Demand

A big story for 2018 was the shortfall in bond demand relative to new supply. This led to higher rates in 2018. That story will continue into 2019.

Bond issuance pressures yields higher. This is important even for those who only focus on equities because it impacts the rate at which future cash flows are discounted.

Solely in terms of US issuance, there is at least $80bn per month coming on the market from the Treasury and $50bn from the Fed ($130bn total). The Fed is a seller and the ECB is now ceasing to be a buyer of EU sovereign and corporate debt. 

In general, you have five main sources of buyers and sellers:

(1) developed market central banks and governments,

(2) emerging market central banks,

(3) commercial banks,

(4) retail/bond funds, and

(5) pension funds and insurance companies

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Going through them individually:

(1) DM central banks and governments are net sellers, as mentioned. G4 central bank balance sheets peaked in Q1 2018. Their flows will decline by an addition $550bn in 2019. The Fed is selling, the ECB is flat, the BOJ is a buyer (but not to the extent that the Fed is a seller), and the BOE is flat.

(2) Reserve growth is flat or only modestly up, so foreign demand for bonds is limited. Emerging market FX reserve growth falls as oil falls, which it has.

A big part of the foreign official equation is the outsized impact of China, which has to deal with controlling the pressure on the yuan due to US tariffs and a slowing in its economy. They can handle that process through swaps/repos temporarily, but requires use of FX reserves in the long-run. If China were to free-float its currency the yuan would run above 7 versus the dollar. They can’t do that if they wish to negotiate in good faith with the US.

The PBOC’s assets peaked in early 2018 at $5.7 trillion. They are now $5.2 trillion, a decline of $500bn.

Your number one rule for tracking global financial flows is the growth in FX reserves. When this doesn’t grow, demand for safe assets, particularly US Treasuries, isn’t going to grow either. This is a problem when the US is increasing its fiscal deficits and pushing more bond supply on the market.

EM reserve growth excluding China should be on the order of $15bn to $20bn per month in 2019. This should put foreign bond demand at around $100bn to $150bn in 2019.

(3) Commercial bank demand is driven by its need to comply with regulatory measures. Commercial bank demand for liquid assets has fallen due to a drop in excess deposits, which peaked in Q1. 

Note that when Treasuries become less expensive relative to the overnight index swaps, holding Treasuries becomes more attractive for regulatory purposes. 

Overall, banks’ reserve growth is the slowest in eight years and banks already have enough liquid assets to satisfy requirements before needing to accumulate more, even if they were to suffer a modest drop in reserve holdings.  

Banks are likely to only offset approximately $300bn of the supply coming on the market.

(4) Retail buyers might take in about half a trillion in bonds in 2019 (through the flows into global bond funds).

Retail flows are also fickle year to year and mostly follow the direction of the market. For example, when the stock market does poorly, retail flows taper off because they view it as an indication that investing in the market is a bad idea. When the stock market does better, retail flows increase because they view investing in the market as a good idea. This is largely backwards thinking, but is the predominant bias that shows up in the data.

(5) In terms of developed market pension funds and insurance companies, demand for bonds was strong among these entities whose behavioral tendencies largely operate opposite of retail.

Namely, when retail sells in a market sell-off, pensions and insurance companies are buying because they are incentivized to keep their allocations to certain assets steady. Likewise, when retail is buying when the market does well, pensions and insurance companies tend to be less likely to buy. As a whole, pensions and insurance companies are net buyers year to year because they, by mandate, must invest their money rather than letting contributions sit on the sideline.

2018 was a strong year for pension fund/insurance bond demand due to the rise in rates. In 2019, this is likely to continue with likely inflows anywhere from $550bn to $700bn.

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Adding It Up

Adding up these figures in terms of total debt issuance and total ability to buy among all parties, you are likely to see a reduction in bond demand of $300bn to $400bn in 2019, with an increase in net bond supply of $120bn to $150bn. Bond demand will expect to be the lowest since 2008.

This means the bond supply/demand deterioration should expect to come in at $420bn to $550bn in 2019.

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Asset Class Implications/Outlook

Credit – Duration is not attractive and corporate credit yields should expect to move higher. The only long trade in credit you can feel comfortable with is toward the front end of the Treasury curve where you get around 2.8%-2.9% nominal with no substantive price risk.

Equities – Even with the earnings growth in US corporations of about 10% in 2019, this should expect to be at least partially offset by the rise in yields when it comes to the pricing of equities. This means flatter, more volatile markets.

The Fed rate hike schedule in 2019 will have material implications. If they move just once in 2019 to go along with the December hike, this will keep them in step with market expectations and limit Fed policy’s influence on financial market volatility. This would be beneficial for equities.

Mathematically, each 100-bp parallel shift of the curve would affect US equities prices by 20%. The rise in yields in October is what caused a 10% correction in the S&P 500.

If they’re moving up toward 3% or even above, which now seems unlikely – inflation risks are tilted to the downside – this would be a drag and more so for value and defensive sectors relative to growth.

Rates – Modestly short (i.e., expect them to go up). Spread trades continue to look attractive in various money markets (e.g., euro-dollar, LIBOR, 3-month SOFR, SONIA, Euribor) and are more transactionally efficient relative to using credit or credit futures.

Commodities – Too broad an asset class to go through because of the various supply/demand considerations. But as a whole, higher real rates and lower liquidity is less supportive of commodity prices.  

Dollar – The dollar is being pushed up through monetary policy divergences with other developed market economies. When that ends in 2019, longer-term structural impediments to the dollar – its fiscal and current account deficits – will weigh on it more heavily. A short dollar trade right now is too early, though the long dollar trade is petering out. Owning gold is an efficient way to get access to this theme and is also cheap relative to its shadow valuation (dollar reserves and currency in circulation divided by the global gold stock).

Euro – The market consensus on the euro is probably inaccurate, expecting it to appreciate versus other developed market currencies. The main reasons are as follows:

(1) euro zone possesses a current account surplus

(2) the ECB is transitioning from a net asset buyer to a net holder

(3) will increase its overnight rate to some degree (low-1% range long-term as a consensus estimate) 

Focusing on number one, financial and trade flows are a notable part of what constitute a currency’s value. The current account is a material part of that, as it captures the trade balance (exports and imports), net investment flows, and foreign transfer and foreign aid payments. Countries with current account surpluses are said to have undervalued currencies. Countries with current account deficits are said to have overvalued currencies, because funding is needed to finance this gap.

In the data, taking it at face value, the EU has a current account surplus of approximately 3.5% of GDP. Nevertheless, that surplus merely reflects large output gaps in the lower-performing member-states, particularly Portugal, Spain, and Italy. Once those gaps are adjusted for and by taking into account recent euro strength’s influence on the deficit, the current account is negative in reality.

The euro also isn’t making progress toward increasing its value as a reserve currency, which diminishes reserve asset-related buying from other central banks. The main reason is because the EU’s primary reserve asset – the bund – is not in high supply and is decreasing. The ECB and foreign central banks own 80% of the market.

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Conclusion

Neither equities nor credit are particularly attractive at this point in the cycle because of the general macro backdrop, which can be summarized as follows:

- US growth is slowing. Growth will slow to 2% or below in 2019 and 2020 as the fiscal stimulus fades.

- Employment will continue to fall, but inflation risks will remain low.

- The Fed is reducing liquidity in the financial system through a mixture of higher short-term rates and through balance sheet tapering. This means we’re approaching the latter stages of the business cycle and is a standard signal to continue reducing equities exposure for those who still have it.

- Both US and global debt are high relative to cash, assets, and income. This means Fed tightening will have no problem slowing down the economy and risk asset performance. Capital is no longer as incentivized to move out over the risk curve into assets like equities and lower-grade and higher-duration bonds.

- Due to the level of bond issuance needed to plug federal fiscal gaps, Treasury auctions are essentially a financial tightening event.

- Safe assets like Treasuries and IG credit are seeing their yields pressured by large debt issuances in both the public and private sectors. Borrowing will continue even as economic growth declines.

- Equities and credit are neither attractive relative to their risks nor relative to each other.

- Moving forward, expect higher term premia, higher yield spreads, higher financial asset volatility, and wider dispersions in prices within asset classes.

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