May 2018 Investment OutlookThe Future Ain't What It Used To Be
June 17, 2018
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.
“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”
The current market environment, maybe more than ever, demands this Fitzgeraldian test of the portfolio manager. For example, how do you build a portfolio that acknowledges, at once, the near-decade sustained bullish trend of equity markets and also valuation levels unrivaled by any point in history except levels prior to the Great Depression and the Dot-Com Bust of the early 2000s? For the trend-follower or momentum trader, the answer is easy: buy stocks. For the valuation-driven or macro investor, the answer is easy: sell stocks. At Martello, we account for this inherent tension between valuation and trend when building portfolios. As an aside, we utilize two different methods to take both the valuation and technical into account: valuation-based overlays and strategy ensembling. These might sound complicated, but in fact are quite straightforward and we believe the sensical way to tackle this issue. In both cases, what this means is that we give weight to both the value and technical factors. When valuations are cheap and the trend is bullish, we load up our exposure. When the picture is less clear, we reduce our exposure to more modest levels. When all signs are bearish, we can throttle down all the way.
In addition to equity market valuation, we continue to see competing signals in different segments of the fixed income market. Any regular reader of our monthly notes knows that we have been harping on the rising risk of traditional fixed income approaches given the prospects of rising inflation in the US, low real interest rates, and the Fed’s expectation of additional rate hikes in the coming months. In the corporate world, years of utilizing cheap debt financing to buy back shares has left companies significantly more levered. As a side-note, research has shown that corporations generally have a bad record of timing corporate buybacks. Most tend to do it to further drive equity prices higher (and it makes sense to buy back rather than increase dividends from the investor’s point of view) but these buybacks often occur near the top of a cycle.
Even in investment grade credit, to quote the famed market philosopher Yogi Berra, “the future ain’t what it used to be.” A recent paper by PIMCO showed that A and BBB-rated credit, the lower end of the investment grade universe, have more than 50% higher leverage today than before the Great Financial Crisis (Figure 1 below) and the investment grade universe is comprised of higher-leverage borrowers (Figure 2). At the same time, interest coverage ratios for this universe (a ratio showing how much money a company makes compared to its interest expense on debt) has fallen to levels near or below the depths of the financial crisis (Figure 3). Think about that for a second; by this metric, the credit quality of these companies is near the same levels as at the bottom of the worst recession since the Great Depression, despite all the economic progress over the last decade. In fact, interest coverage ratios for these companies have been FALLING for years despite steady economic growth, record corporate profits, and historically wide profit margins.
On one hand, you can understand the rationale for companies to do this; levering up when debt is cheap is Corporate Finance 101. If the cost of debt is less than the cost for issuing equity, borrowing makes more sense than issuing stock. The problem with debt financing, however, is that it creates additional inflexibility when things take a turn for the worse; you can reduce or suspend the dividend to your equity holders, but that is not an option when the bondman cometh for his coupon. The likely result of a significant recession, which would almost certainly further impair companies’ ability to service debt, would be what’s known as a “ratings migration.” A ratings migration in this context simply means a lot of companies would be re-rated to lower credit qualities to more appropriately reflect their financial position and leverage levels, and therefore higher rates on debt to reflect this increased credit risk. Depending on how quickly that happens, this could cause significant forced selling pressure from index-based strategies that would be forced to sell if a bond falls below the mandated universe of credit quality.
There are deeper implications for investors here, not only in credit markets but also for stocks. As the chart below shows, equity market volatility and credit spreads are very tightly linked. This isn’t a coincidental phenomenon; if a stock is a claim on a company’s future profits, it would make sense that stocks would become more volatile in times of when debt is more expensive, because more expensive debt obviously imperils a company’s profitability.
While the additional leverage and deteriorating credit quality is concerning on its own, we also see signs of structural weakness that increases shock risk in fixed income markets. One of these signs is the seemingly disorderly reaction of markets to negative events. Jared Dillian of Mauldin Economics covered this in his recent piece “Wall Street Fired Too Many People,” highlighting the price response to the Toys R Us bankruptcy announcement and the recent spike in Italian bond yields after the election. In both cases, which Dillian calls an “instantaneous blowup in the capital markets,” he highlights that these risks should be priced in over time, and the fact that they weren’t shows structural problems in the market. The Toys R Us bankruptcy, for example, should not have caught investors off guard, as credit analysts should have seen deteriorating financials for quarters or years, and this bankruptcy risk would have been slowly priced over time. There are likely several reasons for these structural failings, including the reduction in market making activity in more opaque markets such as bonds; dealer inventory in these securities has plummeted in the years since the crisis due to regulatory factors. Once again, the impact of the passive investing revolution is also at work here; with more and more assets linked to index-based products or quasi-indexed strategies, research on individual securities has been devalued in favor of buying/selling a whole basket.
Back to Fitzgerald’s quote, it is important to remember that this is just one side of two opposing views. Despite our perception of increasing risk in fixed income, some of our models continue to utilize various government and corporate bond ETFs for a variety of reasons including diversification benefit and income potential. As we mentioned above, we build our models by incorporating many factors in combination. However, given the structural issues mentioned above, as well as seemingly deteriorating fundamentals and a poor macro picture for bonds (rising rates, increasing inflation, etc.), investors must be increasingly aware of the hidden risks in their bond portfolios.
We thank our readers, as always, for your time and interest. As of this month, we have stopped generating the usual second half of our monthly write-up, which summarized the previous month’s market returns and recent events. If you would still like to receive this information monthly, please feel free to let us know and we may include it again in the future.
Arthur Grizzle & Charles Culver
The information contained in this presentation is qualified in its entirety by the following disclosures which must be read in conjunction with the presentation. The presentation is intended for sophisticated investors for informational purposes only and is not intended to constitute investment advice or recommendations by any party. Unless otherwise indicated, information, data, strategies and opinions included in the presentation are provided as of 06/17/2018 and are subject to change without notice. In accordance with relevant SEC advertising regulations, a full list of trades and investment recommendations is available upon request. Past performance is not a guarantee or a reliable indicator of future results. The views and strategies described herein may not be suitable for all investors. You should consult your financial advisor regarding such matters. The material contains the current opinions of the author, and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based on proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. This material contains information that has been prepared from original sources and data believed to be reliable. However, no representations are made to the accuracy or completeness thereof. Investing involves a variety of risks and may be only appropriate for sophisticated persons who can afford a loss of all or a substantial portion of their investment. No part of this material may, without advance written consent, be copied or duplicated in any form by any means. There can be no assurance that any client’s investment objective will be achieved or that a client will not lose a portion or all of its investment account. The investment return and principal value of any investment will fluctuate over time. No chart, graph, or other figure provided should be used to determine which investment strategies to use or which securities to buy or sell. No figure above should be taken as a recommendation or endorsement of a specific security, sector, or strategy. References to market or composite indexes, benchmarks or other measures of relative market performance over a specified period of time are provided for information only and do not imply that any client account will achieve similar returns, volatility or other results. The composition of an index may not reflect the manner in which a client’s portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. You cannot invest directly in an index.