Choose your side
MONTHLY INVESTMENT BRIEF
Laurent Denize – Global Co-CIO ODDO BHF
1 market, 2 readings
The stabilisation of the US banking system put investors’ minds somewhat at ease last month. But it is too early to say that financial instability is now behind us. While stress is not being manifested in exacerbated volatility (it’s actually the opposite), it has shown up in the recent declines in long-term market interest rates.
Against this backdrop, it is worth mentioning the divergent anticipations of the equity markets and the bond markets.
Equity markets have cheered the one-off improvement in macroeconomic conditions and companies’ ability to keep their margins very high.
- Global macroeconomic momentum looks more encouraging, with gains by the global composite PMI index. Business activity is still robust in services; the job market is holding up well; and wages are staying at high levels. Meanwhile, while financial conditions have tightened, they still bear the mark of a continued positive trend in surplus savings.
- Central banks’ attitudes have evolved. The Fed, for example, is considering a pause in rate hikes in reaction to uncertainties in the banking sector and the considerable tightening it has already made. This is less the case with the ECB…
- Companies’ quarterly results are expected to reach record levels. With 60% of companies already having reported, aggregate earnings have posted more than 15-year highs.
- Lower oil prices and a weaker US dollar are making positive contributions to most European companies’ earnings.
Bond markets do not seem to share this enthusiasm.
- The economic recovery is restricted to a few sectors. The job market is on the verge of slowing down, and the cost of living continues to rise and to eat into real incomes. The impact of higher interest rates is beginning to show up, as seen in the difficulties encountered by US regional banks. The underlying trend is glum, and GDP growth is expected to be anaemic in the second half of the year, in both developed and emerging economies.
- The consensus is still pricing in two rate cuts in 2023, which would mean the Fed would be throwing in the towel as a soft landing becomes increasingly unlikely.
- An agreement on raising the US debt ceiling is unlikely in the short term, with the two political parties at loggerheads; this is a source of stress, given the matter’s urgency (with an early June deadline).
- Tighter credit conditions will trigger a steep rise in default rates in the coming years and darken the real-estate sector’s outlook.
So whose side are we on?
We are on the bond markets’ side. Granted, companies have demonstrated an impressive ability to weather the current environment. Their earnings have beaten the consensus by more than 13%. But this might be their swansong. With the tightening of financial conditions, paired with the end of surplus savings, it appears to us that the stage is set for a downturn in margins, at the very moment when valuations on the whole are still at high levels. An analysis of index performance reveals an impressive dispersion. 30% of the S&P’s performance is down to the GAFAMs (Google, Apple, Facebook and Amazon, Microsoft) alone; the 495 other stocks have traded almost sideways (+3%). Much the same is occurring in Europe, but with luxury goods stocks in that case, rather than techs. Moreover, this performance has been driven mainly by the repricing of multiples in reaction mainly to the recent fall in long-term rates. But those market rates can go lower only if the economy worsens considerably, forcing central banks to lower their rates. If that happens, obviously, company margins, which are currently at all-time highs, would suffer a backlash from the macroeconomic downturn. The impact of shrinking future cashflows would then be far greater than the positive impact of lower interest rates when discounting these same cashflows.
So how are we positioned?
We are sticking to our slightly conservative bias on global equities, regardless of region. However, based on recently observed points of improvement, a steep drop in business activity is unlikely. So we see no reason to panic.
Two options for investors:
Option 1: Sell a portion of their equity portfolios and invest the proceeds in short-dated high-yield bonds. Yields of 5.3% are on offer with an outsized risk/reward pairing. Spreads would then have to widen by more than 450 bps before investors began to lose capital on a one-year horizon, a scenario that would correspond more to a severe recession than a mere slowdown.
Option 2: Hedge a portion of their equity portfolios by buying put options, exploiting the recent receding in volatility to pay out a premium that is currently reasonably priced. In Europe, hedging 25% of a portfolio (until end-August 2023) with a put that is 5% out of the money would cost you 0.50%. Not bad after year-to-date equity market gains of almost 15%.
Bottom line, we are sticking to our defensive bias of last month, focusing on growth stocks and exposure to corporate and government bonds on the short section of the curve. We do believe that the recent banking stress is just one more sign of a coming economic contraction.