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Sharpe Thinking: a disconnect between markets and economic reality

Contributor
  • Aoifinn Devitt

    Head of Investment Ireland, International

What’s moving the investment landscape? In these turbulent markets, we bring you views from our portfolio managers, analysts and economists, delivered by our Investment Office – an independent body with the goal of ensuring that our investment teams perform in the best interest of clients.

April was a month of extremes. The S&P 500 rose by 12.7%, its strongest monthly performance since 1987. Following the lows recorded in March, its overall return over the last 12 months is now flat. Meanwhile, global economic news plunged to new depths as the oil price hovered at multi-year lows.

The picture is particularly bleak in the US. Corporate earnings remain poor, while news that the US could impose more tariffs on China has created yet more uncertainty. GDP contracted in the first quarter, while 30 million people have applied for unemployment benefit in the last six weeks. While the fall in GDP is not quite as sharp as the decline in 2008, it confirms that the US now has one foot in recession.

This stark disconnection between markets and the economy bewildered investors and emphasised how central-bank liquidity and stimulus have shored up sentiment. Our Economics team believes that even with fiscal and monetary easing, it will be hard for the economy to deliver a swift ‘V-shaped’ recovery.

US Small and Mid Cap Companies (SMID): an emerging divergence

Considerable attention has been paid to the dominance of large US technology stocks, which now represent almost 25% of the S&P 500’s market capitalisation.[1] This phenomenon is almost certainly behind the dogged outperformance of growth companies over value stocks in the recent rally.

Our US SMID team has noticed a similar phenomenon among American small caps. The Russell 2500 index has declined by about 25% since the start of the year, compared to the S&P 500 which has fallen by about 10% – implying an attractive valuation gap.

The team also notes a similar disconnect between value and growth and suggests that this is partly due to lower interest rates. As rates have been cut from about 3% to broadly zero, growth assets are supported as cash flows that occur later on are discounted at a lower rate and so are worth more today.  This is particularly interesting as it is usually value stocks that lead us out of a bear market.

Virus valuations: emerging markets

Emerging markets continued to underperform their developed counterparts in April, despite recording relatively strong growth of more than 9%. Our Global Emerging Markets team notes that the price/book ratio for emerging markets is currently 1.23, the lowest for ten years and a 38% discount to developed markets (compared to the long-term discount of 16%). This is two standard deviations below its 10-year average and close to levels last seen during the financial crisis.

Liquidity or solvency: what is driving markets?

The VIX has stabilised at about 40, indicating that some of the market’s fears have subsided. But uncertainty is still rife, shown by the inability of most companies to provide any guidance on earnings.

It seems that this market strength is largely liquidity driven. But should we be more focused on solvency? Liquidity is ensured by lavish central-bank purchase programs, which have supported both equity and bond markets: both our equity and fixed-income traders have reported robust volumes in recent weeks. The Federal Reserve (Fed) also recently announced it would broaden its Main Street lending program by expanding eligibility and reducing the minimum loan size.

Solvency, on the other hand, points to the risk of defaults. It seems that this has not yet been fully priced into markets, probably because the brunt of the economic shutdown is likely to be felt in the second and third quarters.

Fixed income: an influx of fallen angels

Although the outlook for credit fundamentals remains poor, credit curves for higher-quality credit – investment grade and the top end of high yield – have returned to their normal steep shapes. This is because risk premia have declined faster at the front end than at the long end, following the rush of central banks and policymakers to support companies and debt-capital markets.

Our Credit team notes that fallen angels – or issuers downgraded from investment grade status – have been treated differently in Europe and the US. While the European Central Bank’s debt-purchase program has supported BBB-rated issues, its exclusion of fallen angels means there is a greater incentive for companies to maintain their investment-grade status.

These European bonds have outperformed their counterparts in the US, where the Fed is supporting a broader cross-section of issues – including fallen angels. This suggests there are numerous opportunities to seek relative value in credit markets, something that our flexible-credit strategies attempt to do through high-conviction, bottom-up security selection.

DISCLOSURES
disclosure 1^‘Tech continues to dominate’, published by Investor Place on 1 May 2020.

For information purposes only. This is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes.

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging markets securities can be significantly more volatile than the prices of securities in developed countries and currency risk and political risks are accentuated in emerging markets.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities.

Investment-grade securities are securities that are rated at least “BBB” or unrated securities of a comparable quality. Credit ratings are an indication of the risk that a security will default. They do not protect against market risk.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Russell 2500 Index measures the performance of the small to mid-cap segment of the U.S. equity universe, commonly referred to as “smid” cap.

Indexes are unmanaged and investments cannot be made in an index.

VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.

Small-company stocks may be less liquid and subject to greater price volatility than large-capitalization stocks.

Standard deviation is a historical measure of the variability of returns relative to the average annual return. A higher number indicates higher overall volatility.

Hermes Investment Management Limited.