Fundamental value in a risk-free free world
The reach for yield in an ultra low interest rate environment was always going to have some distortionary consequences. The impressive rally of fixed income assets across the risk spectrum over the past five years indicates one of the ways that this has been manifested.
Yet while fixed income spreads have been squeezed investors competing for a diminishing supply of inflation-beating income streams are being pushed to take on ever more risk. This has meant that dividend paying stocks, particularly blue-chip companies, are now vying ever more strongly with bonds for investors’ attention.
“I think the right decision is to be in equity over fixed income, though there’s higher risk now than there was at the beginning of the year,” says Patrick Armstrong, chief investment officer at Armstrong Investment Managers. “It was pretty hard to say equities were expensive coming into the year when the S&P was about 12 times earnings, but now you’re looking at 15 times earnings.”
These inflows are already having an impact. Over the past five years the IMA Global Equity Income sector has significantly outperformed the IMA Global sector returning just over 39 per cent versus 25 per cent respectively to the end of April.
While not conclusive evidence that this is a by-product of central bank policy, this outperformance suggests a strong preference for dividend stocks. This, of course, has fed through to the price with a number of popular income paying stalwarts now looking quite expensive relative to the broader market.
Indeed at current valuations even long term supporters of these stocks are getting nervous.
“We are getting out of these areas now,” Armstrong says. “We’ve been a holder of AT&T, Verizon and BCE for the last few years based on the defensive characteristics you get and the high dividend relative to where bond yields were. Now though Verizon is trading at 18 times earnings and we’re concerned that these are quite lofty multiples.”
For those familiar with the Bank of England's description of quantitative easing (QE) it should come as little surprise that stocks would be one of the beneficiaries of current central bank policy. One of the central transmission mechanisms of QE is the so-called “portfolio balance effect” where investors are forced out of “safe haven” assets into higher risk investments.
What is perhaps surprising, however, is that despite the recent rally on some metrics equities not only look cheap relative to other asset classes, they look exceptionally cheap. A new paper written by Fernando Duarte and Carlo Rosa of the Federal Reserve Bank of New York suggests that “most [central bank] models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years”.
This, the authors posit, is due to the fact that the equity risk premium – or the expected rate of return minus the risk free rate – is at its highest point since the start of the data.
Yet before suggesting that Mrs Miggins plough all of her metaphorical life savings into equities one might ask how it is possible for these markets to seem so promising while economic growth in the developed world is still far short of what could be considered a recovery trajectory?
And as the Bard would say - Aye, there's the rub. A high equity risk premium reflects both the assumption that the rate of return from the asset class will be largely in line with its long-term average and the fact that ultra low interest rates have pushed the risk-free rate down to historically low levels.
In these exceptional times it can quickly become unclear what constitutes euphoria and what is a reflection of structural shifts in portfolio managers' risk tolerance. As Toby Nangle, head of multi-asset at Threadneedle Investments, put it this week:
“By bidding yields on government bonds down to current levels, monetary policymakers have largely extinguished government bonds as an effective portfolio hedge. Investors can now decide to either increase their risk appetite on a structural basis and hold more risky assets (that is to say assets that are positively correlated with equities), or increase their cash positions and hold less equity than they would otherwise do to retain the same level of portfolio risk.”
Unfortunately this clash between Econ 101 and Portfolio Management 101, or so Nangle dubs it, makes an analysis of the current situation immensely complicated. There is no doubt that overall equity markets appear to be less stretched than investment grade and high-quality government debt markets but as valuations creep up so alarm bells should start ringing.
Moreover, there are key questions to answer about responsible portfolio management in an environment of above-target inflation and near zero returns on cash. The cost of staying on the sidelines, even if markets do look expensive, may impose significant pressure on managers to act against their better instinct.
The reality investors face is that in an environment where there’s no real risk-free rate doing any sort of fundamental analysis is getting progressively more complicated. Nevertheless, it should not be forgotten that even in exceptional circumstances valuation is important. History has not been kind to those who have forgotten that particular golden rule.