July 08, 2021
Financial markets have experienced an exceptional 2020 and beginning to 2021. Everything about a normal economic and market cycle has run in fast forward: The fastest collapse in equity markets in March 2020, swift policy intervention, and a historical rebound, followed by almost record exuberance – all within 15 short months. That leaves investors in a difficult spot: In contrast to mid-2020, when significant fear was balanced by attractive valuations, now there is economic optimism, but scarcely any value left. Should you continue to chase it?
Fundamentals, policy support, and pricing – Improving, but already priced in
There is no doubt about the direction of economic and corporate fundamentals – reopening, pent-up demand, and corporate cost control through 2020 all point to sharply stronger growth and earnings. Combine that momentum with highly supportive policy settings and there is a clear setup for very strong market performance.
But there are two clear caveats to this positivity:
First, growth and earnings will likely be strong, but just how strong and sustained is still up for debate. Quarterly earnings are currently flattered by easy comparisons, but these will become gradually more difficult as the year wears on. And there are questions about the sustainability of the current pace once support measures are reduced, along with the potential for permanent scarring in some sectors.
More importantly, how much of the good news is in the price? Simple earnings multiples provide evidence that the recovery is baked in. Current elevated price-to-earnings (P/E) levels can be dismissed as a product of depressed earnings, but 2-year forward multiples (presumably encompassing a full recovery in earnings) have also expanded significantly over the past 18 months.
Earnings multiples, current and forecast
Credit markets – how much value is left?
Credit markets face a similar challenge. It’s broadly expected that improvements in earnings will ease the burden of elevated leverage levels and improve debt flexibility, but credit market pricing already gives that benefit to issuers.
Investment grade (IG) credit spreads at an index level have more than recovered the spread moves since the onset of the COVID-19 pandemic. What is even more surprising to us is the distribution of spreads within the Bloomberg Barclays US Corporate Investment Grade Index. The right “tail” of widely trading issuers is now almost identical to January 2020. Compared to mid-2020, when the index was trading at 129 basis points (close to the post financial crisis long-term average), the small yet important right tail for active managers has completely normalized.
Distribution of investment grade credit spreads
Looking at the lower end of the credit market
US CCC Spread distribution
US HY Air Transport Spread distribution
Source: Bloomberg, ICE.
What about the lowest-rated portion of the credit market, those securities theoretically closest to default?
CCC-rated spreads are near the tightest levels since 2010, with an abundance of demand and capital markets open for even the weakest of names. If a company avoided default in a narrow window of market stress in 2020, then some of the most accommodative financial and economic conditions in history mean investors perceive forward-looking default risk as very low.
In some specific affected areas, such as air transportation, spreads remain wide of their post-crisis tights, and there are selective opportunities. It’s worth noting that you must visit one of the most fundamentally impacted sectors to find spreads above their post-crisis tights – though still well inside long-term averages.
Starting prices matter
An obvious (but given the backdrop, important) statement is that entry price matters. In an environment where valuations are tight, we think there is clearly a narrower pathway to achieve acceptable returns. The best case would be a continued grind tighter, achieving only modest returns – but crucially not “missing out,” a key driver of investor behavior. In contrast, the scenario where spreads or yields increase, even if to nowhere near long-term averages, produces significant negative returns.
Recent examples are found in US Treasurys, which had an outstanding 2020. Long Treasurys returned almost 18% for the calendar year. But that rally left yields pricing low growth and inflation in the long term. The recent rise in yields (though small in historical context, with levels still well below historical averages) almost erased the previous year’s gains in just two months.
In a similar vein, the outlook for credit markets is limited by the starting spread level. The chart below compares historical monthly spreads on US IG credit (since 1990) to the subsequent 6-month excess return. Around current spread levels, the most common outcome is still a (small) positive return, but the returns are highly skewed, with asymmetric downside risk and capped upside opportunities.
Investment grade 6-month return outlook versus starting spreads
With this backdrop, how do we see appropriate positioning within our portfolios?
Maintain liquidity, find low-beta carry
Tights spreads mean low opportunity cost such as in short, high-quality and securitized credit.
Targeted risk in higher-beta asset classes
Consider targeted holdings in high yield BB-rated, emerging markets, and low BBB-rated/crossover credit.
Maintain and build risk offsets
Protective positions can add value/offset high-beta allocations, including options. In time, rates may provide more attractive entry points.
Reduce any “generic” investment grade credit risk
When it’s a poor return outlook and asymmetric risk-reward – reducing generic investment grade can be appropriate.
Be realistic on return targets, after an exceptional 2020
Overall, it’s unlikely that over the next six to 12 months that any combination of assets can provide the returns seen through 2020 and into 2021 so far. With that in mind, investors broadly face a choice – either increase risk in an attempt to repeat returns seen in the rear-view mirror or accept the pricing reality across all asset classes and begin preparing for the next set of opportunities. Don’t forget that the wave of central bank support has been a primary catalyst to get us to these levels. As the year progresses, more questions may be asked about the sustainability of the extremely supportive backdrop, and the widely expected hand-off from monetary to fiscal policy may not be as immaculate as the market anticipates.