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Sharpe Thinking: reality sets in

  • 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 ensuring that our investment teams perform in the best interest of clients.

Cold hard truths

As the majority of us come to the end of our second month of remote working, it seems that some of the novelty is gone. For markets, too, the hard reality seems to have emerged. Last week, the S&P 500 fell to a three-week low. Markets appeared troubled by the latest round of poor economic data and the enormity of the mounting bill of stimulus and aid packages that aim to ease the pain of lost revenues.

This reality check in equity markets mirrored what we have seen in the fixed-income universe since the start of the crisis: a preference for lower-risk government bonds and a stark aversion to riskier high-yield credits, where spreads have soared.

The gap between S&P 500 dividend yields and US 10-year government bond yields has widened dramatically in recent weeks and is now eight standard deviations above its 14-year average.

This is because dividends have remained consistent, while government-bond yields have fallen as investors seek them out as safe havens. However, this relationship may be on the brink of change as dividends and share buybacks come under pressure – something that could bode well for high-yield credit.

Fixed income: the changing face of high-yield credit

Our Credit team notes that there has been a sustained focus by companies on raising liquidity in the face of heightened uncertainty and increased volatility.  This mirrors the triage-type efforts in place among private lenders to ensure that borrowers avoid defaults and stay afloat until activities can resume.

Within public markets, the premium on near-term money led to a temporary inversion of investment-grade credit curves – although they have since normalised and returned to their typical gentle upwards slope.  

Since then, issuance has reached record levels and the investment-grade market has returned to relative normality. Meanwhile, the high-yield market remains distorted and the number of fallen angels – or issuers downgraded from investment-grade status – that recently descended has raised the average credit quality of the asset class.

While fallen angels have altered the composition of the high-yield index in the near term, the market has experienced even greater change over the past decade. Our Global High Yield capability recently reached its 10-year anniversary, which we used as an opportunity to consider how the market has changed in terms of breadth, underlying credit quality and its emphasis on sustainability.

Equities: a dispersion in outcomes

Our Global Emerging Markets team notes that the effect of the coronavirus pandemic has been highly variable across countries, with a relatively contained outbreak in Asian countries outside of China and a more severe scenario across certain Latin American countries like Ecuador and Brazil. There has been a subtle shift in the timeframes that investors seek to discount, as phase one (that is, the lockdown) is shifting to a more protracted and uneven phase two (when economies start reopening).

Our analysts build models that factor in the current disruption and anticipate a return to normal growth and trading conditions at a certain point in the future, which they believe could be 2021 or 2022. The recent suggestion by Federal Reserve Chair Jerome Powell that the US economy would not recover until the end of 2021 is further evidence that this date is being pushed further out. This will simply prolong the current period of uncertainty and make estimates less robust and prone to change.

Meanwhile, our Asia ex-Japan team notes that many companies are trading at lows last recorded during the 2008 financial crisis. Trailing dividend yields are a full standard deviation above the mean, while price/book valuations are one standard deviation below their 10-year average. Although investor risk aversion is high, this potentially presents an interesting entry opportunity for the asset class.

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.

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.

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

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.