Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Higher equities will lead to dangerous valuations
Peter Garnry
Chief Investment Strategist
Summary: In this late stage of the economic cycle the strong equity market is perhaps the most puzzling question out there among investors. What is holding up equities might be that lower rates create a substitution effect where robust dividend stocks, minimum volatility stocks and massive buybacks fueled by debt issuance all drive equity valuations higher and closer to that of bonds. We argue that the worst case scenario for equities would be an interest rate shock set in motion from increased fiscal spending causing inflation to rise. In today's equity update we also zoom in on Netflix that is experiencing hangovers from the Q3 earnings release.
Global equities are still bid as investors are buying into the argument that central bank easing and US-China trade deal will pull economic growth out of its slump. The Fed is agreeably becoming more aggressive, better late than never they say, but is it enough to get ahead of the curve? Our view is that the Fed’s models are not able to properly incorporate the dynamics from higher tariffs and disruptions in supply chains for US firms. Otherwise, they would not have been so complacent over the past 18 months. What goes for the US-China trade deal the probability of a grand deal is still low before the US elections next year in November. On Thursday a potential turn for the negative could start again as US Vice President Mike Pence delivers his second speech on China next Thursday. He is known for being one of the hawks against China and this speech could dilute the trade negotiations that just recently took place in Washington.
Another potential dimension to the stubbornly high equity prices and valuation is the low interest rates and increasing amount of negative yielding debt instruments. This phenomenon is forcing investors to rethink portfolio correlations and expected return profiles for asset classes. Many retail investors are buying equities because of the ‘what else is there to buy with a return?’ mantra and recent Bill Gross has been out saying investors should buy robust dividend paying stocks as a substitute for bonds. Another trend in equity markets is the demand for low volatility stocks, again working as substitutes for bonds, which has pushed US minimum volatility equities to a historically high valuation premium currently at 28% above the S&P 500 which already is valued at a 30% premium to global equities. As of September, S&P 500 valuation rose back into danger zone and this with falling profit growth.
The biggest risk facing equities besides the economic slowdown is an interest rate shock which ironically could come if governments finally go all-in on fiscal expansion to reignite global growth because it could cause inflation to rise. With equity valuations pumped up due to low interest rates a cocktail of fiscal expansion, higher inflation and higher rates could be come toxic for real rate returns on equities. Our own valuation model indicates still a positive real rate return expectation for S&P 500 over the next 10 years, but our adjusted expectation is lower as the model has only seen data from 1990-2019 which was a period of ever lower rates.
Last week the Q3 earnings season kicked into gear and so far, results have been better than expected on average although growth rates are coming down. Earnings were likely a positive contributor to returns last week which makes this week even more important as this is the busiest week during the entire earnings season. But the earnings reported so far have helped push down the profit growth rate further so that it currently stands at 1.7% y/y for global equities and -5.3% y/y for EM equities. However, more telling about the earnings so far is that management outlooks are uncertain to such a degree that analysts are still lowering forward earnings.
Netflix shares are lower post the Q3 earnings release despite an initial positive reaction to the result as the numbers were less bad than anticipated. Management talked much more about profitability than growth showing that Netflix understands the new narrative that investors are nervous of these growth stories at all costs. The culprit of investors’ change in attitude stems from the bad IPOs this year including Uber and Lyft, while the WeWork disastrous IPO attempt was the inflection point for investors changing their attitude towards growth. The biggest issue for Netflix is that its net-debt continues to accelerate supporting original content production and top line growth, but the cash flow from operations is still stuck at around $500mn per quarter on average. With competition heating up with most notably Disney entering the market next year this could become a strategic constraint for Netflix. But more importantly investors are paying twice the valuation multiple for Netflix compared to Disney which naturally reflects growth differential but also a clear path to profitability. This valuation difference to Disney will be the battle scene for Netflix’s share price over the next year.
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