In this first article in a new series, Nick Lyster and Amin Rajan ask whether equities are in remission or revival
The current equity rally has sparked a worldwide debate about the future of equity investing, according to the 2015 The Principal/CREATE-Research Survey, Pragmatism Prevails, Opportunism and Equities Rise*. Some say the rally is mostly fuelled by the post-2008 quantitative easing (QE) programmes in the US, the UK, Japan and Europe.
Others contend that these unconventional experiments in monetary easing have lifted equities ahead of growth in corporate earnings. They expect prices to reconnect with their underlying value drivers as the wealth effects drive up earnings. Our survey is the first of its kind to canvass the views of the wider investor community.
The QE programmes in America, Europe and Japan have aimed to stimulate their economies by two means: zero bound interest rates to boost spending and jobs, and booming stock markets to create the wealth effect.
Rates have since hit all-time lows. And equities have soared to their all-time highs. The feel-good factor is back. But doubts persist whether these economies are generating the necessary earnings boost to justify current valuations, while capital expenditure and productivity continue to stagnate.
The US economy is growing well. The green shoots of recovery are evident in Europe and Japan. But emerging markets are slowing down. Debt overhang remains a drag on growth everywhere.
Investors worldwide still question whether the US economy is at stall speed, where a premature rate hike cycle by the Fed could tip it into recession and hit equities indiscriminately everywhere, since the US sets the tone for the rest of the world.
There is no roadmap for central banks in this surreal world of negative yields where investors get back less than they lend. No one knows for sure how it will end.
Despite deflationary fears, however, reflationary policies appear to have an upper hand – for now. Lower-than-normal policy rates and lower-than-normal growth rates are here to stay. Market spikes will be common.
Investors’ sentiment towards equities will continue to blend caution with opportunity, in the belief that while it is unwise to ignore central bank pump priming, it is equally unwise to ignore improving fundamentals.
Such pragmatism sees the world of investing as cyclical and self-correcting. Notably, 79% of our survey respondents do not see the cult of equity as dying.
Equities acquired cult status after delivering stellar returns during the 1950s and from 1982 to 1999, to the point that validated the risk-return trade-off. They also delivered solid diversification benefits within a 60:40 equity-bond portfolio to the point where asset allocation became formulaic. However, it all ended in March 2000 when the technology bubble burst. Having averaged 16 times cyclically adjusted earnings since 1881, the S&P 500 soared to 44 times 2000 – reaching its worst-ever point of overvaluation.
Equities duly entered the ‘lost decade’ when they were roundly outperformed by bonds. They were effectively forced into a self-healing phase, according to 30% of our respondents and a further 44% consider this is a possibility.
The two bear markets of the last decade have delivered the long overdue correction. Equities are in the ascendancy as they offer a better deal now – just as on other occasions in the past.
Even in rock-solid bond-buying markets like Germany and the Netherlands, equities have gained traction lately in an agnostic search for decent returns. Investors are willing to give equities the benefit of the doubt, while bonds trade at stratospheric values far removed from reality. Pragmatism underscores this qualified support, however.
The known unknowns
QE is a journey into the unknown. For investors, there is nothing predetermined about its course or outcomes. Value traps are as likely as value opportunities.
The US economy has certainly undergone an impressive recovery in the last three years. Yet, for all the Fed’s efforts, the economy has not achieved the escape velocity that allows it to cut loose from the recession mindset. Significant doubts persist:
• Would the Fed leave rates at their zero-bound level for the foreseeable future to sustain the current high market valuations?
• Is the real economy improving to the level where today’s high valuations will soon be justified by improving fundamentals?
• Will the rising dollar hit emerging market assets disproportionately, as has happened in the past?
It is difficult to know how to price assets in a world where rates may or may not rise above zero after six years, while actual inflation – and its expectation – have been converging towards zero. However, despite these deflationary tendencies, reflationary policies appear to have the upper hand – for now.
The Fed is being ultra cautious in winding up QE. In Europe, austerity is giving way to modest export-led growth. In Japan, there is renewed momentum behind the Three Arrows programme. In China, monetary easing is aiming to pre-empt a hard landing.
Investors, therefore, are in the cross hairs. Ageing populations call for cautious investment options. But such options are no longer viable in today’s environment of near-zero real yields.
Investors caught in the middle
In the last decade, equities lost their appeal for pension investors for three reasons: the sheer scale of losses inflicted by the 2000-02 bear market, the introduction of mark-to-market accounting rules in its aftermath, and ageing populations favouring bond investing.
Defined benefit pension plans duly started rebalancing risk by adopting liability-driven investing that progressively switches from equities and other risky assets to bonds, along a preset glide path towards full de-risking. The trend accelerated after the 2008-09 bear market.
However, falling rates and ageing demographics have sparked a self-fuelling downward spiral of rising liabilities, rising deficits, rising solvency risk and rising negative cash flow. Cash injections by sponsors have eased the spiral, not reversed it.
As a result, 30% of respondents expect pension plans to increase their equity allocations. A further 30% of respondents are neutral on this subject. The increased allocations will be largely confined to public sector plans, where the deficits are the biggest.
On their part, private sector plans are now resorting to dynamic liability-driven investment glide paths that favour rebalancing in favour of equities, as bond allocations exceed their pre-set levels. Besides, some are wary of sticking to their original risk immunisation strategies that never anticipated that yield would drop so low as to make a mockery of bond investing.
Pension plans are not the only investor group rethinking their approach to equities. Defined contribution (DC) plans and retail investors, too, are being forced to climb the risk curve for better returns.
Prudence held that retirees or near-retirees should be overweight in bonds and not take risks with their retirement nest eggs. In search of yield, investors are now forced to act contrarian.
In the DC space, the glide path of target date funds is being elongated such that a significant part of the portfolio is still locked into equities in the retirement phase.
Likewise, in the retail space, the new generation of diversified income funds now have a higher allocation to quality equities. Go-anywhere type mandates are on the rise. Low bond yields are not the only contributory factor.
In recent bond issues, there are clear tilts towards issuers at the expense of investors. First, there has been a shift in issuance from floating to fixed-rate bonds, favouring issuers when rates rise. Second, the amount of callable bonds has increased notably, giving issuers the option to redeem their bonds before maturity; and leaving investors with higher reinvestment risks in a rising rate environment.
Asset classes once considered too risky can suddenly acquire safe haven status when the market environment changes. Equities find themselves in that sweet spot. However, it is not enough for bonds to do badly for equities to succeed. Equities have to succeed in their own right. Corporate earnings growth holds the key.
Nick Lyster is CEO of Principal Global Investors (Europe) and Amin Rajan is CEO of CREATE-Research; *Available from email@example.com