Climbing the wall of worry

Markets are climbing a wall of worry and the S&P 500 is close to its all-time high. We suspect it can go through that barrier but that better returns will be had on US high-yield and other stock markets

A few days in Tel Aviv left me feeling naive in comparison to the hard-nosed scepticism of local investors. As discussed last week, it seems to me that fears about a slump in Chinese growth have been allayed (or should have been) by recent data. It is then interesting to hear investors now voicing the opposite concern – that excessive loan growth will cause the PBOC to tighten.

The Chinese market is not alone in climbing a wall of worry – despite all of the angst, it has been difficult to lose money this year, unless you are a yen based investor. The S&P 500 flirted with 2100 this week (our year-end target), leaving it with a YTD gain of 2.3% and less than 2% below the all-time closing high of 2131. Will it go on to a new high or slide back down that wall?

Last week’s data gave plenty to worry about: housing starts and building permits were well below expectations, while Philly Fed and Markit PMI data suggest the manufacturing sector slowed in April. The Chicago Fed National Activity Index for March indicates the coming GDP data release will be soft (consensus expects +0.6% q-o-q annualised in Q1).

However, Q1 has often been a weak quarter and Figure 1 suggests that, though the S&P 500 suffers many periods of doubt, the true ending of a market cycle seems to coincide with a flattening and then decline of employment. US payroll data shows no sign of flagging and, if that continues, history points to a new S&P 500 high in the near future. The fact that initial jobless claims are now the lowest since 1973 gives hope that the US economy still has legs.

Nevertheless, US equities appear expensive (Shiller PE around 25) and the latter stages of the economic cycle are more challenging for profits. On the latter point, 130 S&P 500 companies have so far reported Q1 numbers and the aggregate EPS decline is 8% y-o-y (exceptions are consumer sectors, healthcare and telcos).

With the S&P 500 at our year-end target, we really should be looking for alternatives (or changing the target). One obvious local candidate is US high-yield. Though the much anticipated “great rotation” out of credit into equities never really happened, the predicted relative performance did (see Figure 2).

Equities have outperformed high-yield since 2010, especially since 2012/13 when the ratio of the yield offered on high-yield to that on equities fell to a historical low. The subsequent outperformance by equities has helped move the yield comparison back in favour of high-yield (roughly 8% versus 2%).

That yield ratio may not seem very generous compared to historical norms but the picture is distorted by the turn of the century dotcom bubble that depressed equity yields and the simultaneous sharp rise in the yield on high-yield debt. Otherwise, given the decline in inflation and benchmark treasury yields over recent decades, it could be argued that a ratio of four (high-yield to equity) justifies a switch out of equities and into high yield.

Even if there is a repetition of the worst five year credit loss period on record, a starting yield of 8% suggests the annualised return on high-yield would be around 3%. I very much doubt that stocks would match that return under those circumstances. An average credit loss cycle would give an annualised return of around 5% on high-yield. Given that our five year target on the S&P 500 is 2100, it is easy to see why we favour high yield.

Other candidates to outperform US stocks are other equity markets – they have largely underperformed the US this year and also over the medium term. The Japanese market has been a notable laggard this year and we wrote two weeks ago about the potential for a rebound.

When it comes to the longer term, US stocks had produced a total return of 103.5% in the ten years to end-2015, versus a USD return of only 11.3% in Japan and around 47% in both Europe and EM. In the last five years, US stocks had generated a total return of 80.4% versus a loss of 20.5% in EM (Europe and Japan showed gains of around 25%).

On the basis that returns tend to equalise across regions over the very long term, it is only natural to suspect that the best equity returns will be found outside the US over the next 5-10 years. This is why we continue to favour European and Japanese stocks and suspect that EM equities will come into their own once the commodity cycle has bottomed (we suspect it has not yet done so).

Paul Jackson – Head of Research – Source
András Vig – Research Director – Source