The Brexit vote and the Federal Reserve's decision not to hike rates have ushered in a modest return of volatility, causing investors to rethink how they value equities and the outlook for bond yields. This month, we discuss the realities we face in pricing assets in a low growth and deeply disinflationary environment.
We are halfway through the year, and although smart investors always assess the health of their portfolio, halfway points are a prime check-in opportunity. The basic questions: Are stocks and bonds priced high, low, or just about where they should be? And, what should we expect going forward? The short answers: Equity prices seem reasonable; bond yields are lower than expected (and could go even lower); and markets are more stable than they have been in years, with a big caveat that it's hard to know if or when the next big fissure will appear. We saw sharp equity sell-offs in January and February this year, followed by a rebound to about neutral. It would be unwise to think that another selloff couldn't happen in a heartbeat, but equally unwise to assume that timing the 'when' is particularly feasible.
Markets of late have been treated to a modest return of volatility, largely surrounding the uncertainty of the United Kingdom's Brexit vote. The result was a modest sell-off in equities, a spike in the volatility index as measured by the VIX, and a flood of money pouring into A-rated sovereign bonds, such as Germany and the United States. It pushed yields lower: into negative territory for German bunds and Japanese bonds, down to 1% for UK bonds, and towards 1.6% for U.S. 10-year Treasuries. The trend to low, low rates was then confirmed by the Federal Reserve. Rather than raising the short-term lending rate to 50bps, as had been widely expected only a few months ago, the Fed and its chairwoman Janet Yellen held rates steady, and signaled that the pace of future increases would be slow indeed, with perhaps only one more increase this year. Although the possibility of a "Brexit" was one factor, so too was the slowing curve of U.S. job growth and still modest evidence of strong wage expansion.
That was the "noise." And as we know, some noise always shapes day-to-day and week-to-week trading. For the past few weeks, it was Brexit and the Fed. Once those events fade, they may be followed by either a long or short period of placidity until some other incident or crisis breaks the calm. The question mid-way through the year is: Where are we headed now, not for the next few weeks, but for the next 12-18 months?
The Brexit referendum is simply another one of the market risks, which are neither common nor as uncommon as many would like. Traders can and must position for market reactions, but most investors should not, given that in this case the long-term consequences could cut several different ways, and may not have a simple and quantifiable impact. The larger context is that we may remain firmly entrenched in a low-yield, low-return environment, and there is little indication that situation will change anytime soon.
Debates over whether stocks are fully or fairly valued are as common as the rain and as unresolvable as the fissures that separate religions. There isn't even a consensus on which numbers to use, let alone what constitutes the "right" price level. Accounting standards have changed over time as well, making apples-to-apples valuation comparisons across time problematic, though many attempt to adjust for that.
We know that the forward P/E multiple for the S&P 500 based on FactSet estimates is about 17x, give or take (16.4x as of June 17). But using forward numbers perturbs some people, as forward multiples depend on estimates of what companies might earn, and Wall Street analysts, as well as corporate CFOs, are either too optimistic or too pessimistic, and rarely 'just right'. But we use forward numbers because investors tend to invest in equities because of their future earnings potential and trajectory, as opposed to bond investors, who judge a company based on its past and current risk and debt profile.
Now, is 17x expensive? Cheap? Just right? That is very much an eye-of-the-beholder question. But one clear mistake is to answer it only in relation to how stocks have traded historically, rather than view equity valuation in the context of how other assets are priced at the same time and what inflation expectations are. The value of growth or forward earnings depends very much on investors' perception of how much inflation will "eat into" future gains. And for now, at least, we are in a deeply disinflationary environment. That means that lower growth rates are (in relative terms) more valuable than they would be in a higher inflationary period, in which growth and future earnings would provide less real return because of inflation.
And while it appears that the S&P 500 is headed for a fifth straight quarter of earnings decline, those declines aren't ubiquitous. In the technology sector, for instance, the negative effect of Apple's weak equity performance weighs heavily. The continued collapse of energy and commodity prices also contributes disproportionately to the overall negative perception (though with oil prices rebounding to nearly $50 a barrel, that may reverse to the positive in the last two quarters of the year).
Then there are bond yields, which form the yin to equities' yang. Bond yields continue to head lower than almost all informed investors believed possible or likely. For years, economists and markets have priced in "inevitable" Fed rate increases along with wage growth and inflation, however modest. Other than a few occasional signs of wage growth in select industries, evidence of inflation has been scant. More to the point, yields not only haven't risen; they have dropped even lower, and it is now conceivable that we could be headed to a 1% yield on U.S. 10-year Treasuries, a rate that would have been unthinkable even a short time ago.
Perhaps bonds will reverse, but with even the Fed talking about a host of "new normal" events, it would behoove us to consider not that yields are low, but that they will stay low, and perhaps will fall even lower. Today's world is one in which deflationary goods and plateaued economic growth are creating different dynamics from those contemplated when many of the accepted truths, old saws, and popular canards of investing and economics were developed.
In this environment, neither equities nor bonds generate enthusiasm. At the same time, low returns and low yields offer continual opportunities to invest without either chasing performance as markets roar or plunging into a downdraft as they implode. The valuation or price of equities matters, but perhaps not as much as the prospect for relative return, which includes the dividend yield (which for the S&P 500 at about 2% is above the yield of the U.S. 10-year). Low interest rates look daunting, except compared to the prospect of even lower rates. It would be unwise for investors to assume rates will fall, and then pour money into 30-year or even 50-year instruments, but the knowledge that we may not have reached a bottom in yields or a top in prices should be something of a balm to investors' jangled nerves.
This may be a period of preternatural calm. We soon may face roiling markets or a crisis du jour that causes panic. But it seems unlikely that we are anywhere near either an interest rate tipping point or an equity collapse, and, in fact, may be closer to either continued modest equity gains and bond stability, or even modest continuation of the bond bull. The dual bond and equity bulls may be in a quiet period, but there is little evidence that they have ended.
In the wake of a return to volatility, investors are questioning current asset prices and expectations for the future outlook. Brexit and the Fed's interest rate policy have created a spike in equity volatility and pushed global bond yields lower. As these events begin to fade, we may need to modify our valuation measures and accept that disinflation and plateaued economic growth may mean that modest equity prices and lower bond yields are the new normal.