Market Direction and Stock Trends

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Beware of paying too steep a price for high-quality assets
By: Financial Times | October 11, 2019

• The run into ‘safe’ instruments is starting to look like a stampede

“There are no bad assets, only bad prices” is an adage on Wall Street. It is something that investors herding into supposedly safe, stable corners of financial markets should bear in mind.

With most big economies spluttering and the post-crisis bull market looking vulnerable, it is natural that many fund managers are looking for safety, first and foremost. The latest run of economic data from Europe and the US has been discouraging, and the IMF will next week lower its global growth forecasts, underscoring a mounting sense of pessimism.

If a deep downturn is looming — as some investors believe — then stocks in more economically sensitive industries such as banking and luxury goods, or bonds issued by lowly rated, heavily indebted companies, will probably suffer a beating.

Money has therefore poured into investment-grade debt and steadier, dividend-generous stocks in more defensive industries such as utilities and consumer staples, or companies that are growing quickly irrespective of the economic backdrop.

The result? A record-breaking valuation divergence between supposedly safe and risky assets, as demonstrated by a trio of recent Goldman Sachs reports.

Investors have always preferred more predictable earnings growth, but the valuation gap between stocks with stable and choppy profits — as defined by the volatility of their earnings over the past decade — is now at its widest level in at least the last 35 years, according to Goldman estimates.

A stock market wobble in early September briefly threatened to upturn this trend, but did not do so for long. A flight to safety once again reigns, with investors shunning cheaper economically sensitive stocks in favour of theoretically more resilient ones.

Over the past two years, companies with more volatile growth in profits, such as Apple, Southwest Airlines and Wendy’s, have returned just 1 per cent, while the median company in the S&P 500 has climbed 16 per cent. Stable profit-makers — such as Comcast, Disney or Walmart — have returned 22 per cent, according to Goldman. That is a stark difference.

A similar phenomenon is playing out in the bond market. While the average yield of outstanding bonds has sagged to 1.23 per cent this year, the performance has been mostly powered by highly rated government and corporate debt.

The option-adjusted spread of the Bloomberg Barclays Global Aggregate bond index, which tracks a mix of high-quality corporate and government debt, is just 46 basis points over government debt, when adjusted for the risk of early redemptions, according to FactSet. That is a mere 14bp over the all-time low touched last year. In contrast, the equivalent spread of the global junk bond market — home of the lowest quality credits — has edged up to 502bp, up from last year’s low of 323bp.

In fact, 2019 is on track to become the worst year on record for the relative, risk-adjusted performance of lowly rated CCC bonds, according to Goldman. “This recession-like performance is even more dramatic considering the double-digit returns generated by the broader market,” notes Lotfi Karoui, the investment bank’s corporate debt strategist.

Seeking shelter in safer, steadier corners of capital markets makes sense. Although central banks are once again acting aggressively to forestall what they think are mounting dangers, their limited firepower — with interest rates still at or near record lows and diminishing returns from bond-buying programmes — means that we could well see a global downturn over the next 12 months.

However the sheer extent of the crowding into shelters is worrying. These may be fundamentally solid assets, but valuations look severely stretched. Attention has mostly focused on the $14.5tn of negative-yielding bonds, but across the board investors are paying up for safety.

Goldman itself reckons defensive assets will remain in favour. “Both equities and credit would need to see macro conditions improve, policy concerns to fade and rising inflation expectations and bond yields for a more powerful and sustained rotation?.?.?. to take place,” argues Peter Oppenheimer, chief global equity strategist at the bank. If governments were to abandon restraint and borrow more heavily, that could be a “trigger” for riskier assets to outperform. “But we are not there yet,” he says.

It is true that it would be dangerous to ditch safer assets at a time when economic data continues to worsen at a sometimes scary pace. But given the crowding and elevated valuations, losses for investors could be severe should the manufacturing downturn fail to spread and the global economy regain its footing.

In other words, good assets trading at bad prices can still produce painful outcomes.

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