Equity performance has turned choppy in the third quarter of 2021. Low bond yields imply future low returns. Paul O’Connor, Head of the UK-based Multi-Asset Team, provides an update on markets and explains why – considering some of the drivers of recent performance – investors may want to consider alternatives.
- Encouraged by historically accommodative monetary policies, investors continue to pour money into equities – even as central banks hint at cutting back liquidity over the coming year.
- Meanwhile, in both investment-grade and high-yield bonds, yields and spreads are close to historic lows, which could limit future return potential for fixed income.
- Against this backdrop, investors seeking diversified returns may want to consider alternatives, which include emerging areas of secular growth such as renewable energy and logistics.
While anyone watching the seemingly relentless rise in the S&P 500® Index – up nine of the 10 months through August 2021 – might reasonably feel that world stock markets are still locked in a strong uptrend, the reality is more complicated. As we approach the last couple of weeks of Q3, we see that the main U.S. index has returned 3% this quarter but developed markets outside the U.S. registered -1% returns so far (see Exhibit 1 for Q3 return data). The story is even worse in emerging markets, where government regulatory interventions and financial stability concerns have caused the MSCI China Index to drop over 30% from its peak on February 17 to August 20, with collateral damage across the region. Equity investors have not had an easy time in Latin America (LATAM) either, with Brazil slumping 17% in USD terms so far this quarter. Japan has been a bright spot in recent months, delivering 9% returns in Q3, albeit after having been a major underperformer in the first half of the year.
Exhibit 1: Equities in Q3 Get Complicated
The performance of major indices has started to diverge.
Source: Bloomberg, as of 17 September 2021. Figures shown include rounding. Past performance is not a guide to future performance.
Consensus Stays Bullish on Stocks
Even so, most measures of positioning show that retail and institutional investors are fully invested in stocks. Despite the spotty performance so far in Q3, global equities have still risen by more than a third since the start of 2020 to September 17, 2021, so even an investor who has done nothing will have seen her allocation to equities grow significantly over this time.
Investors haven’t sat still, however; they have poured money into stocks at a record rate this year. If inflows continue at the current pace, global equities will record over $1 trillion net inflows in 2021, which would be greater than the cumulative inflows of the prior 20 years. The Bank of America (BofA) survey of global fund managers shows that the number of managers reportedly overweight stocks is now close to record highs (see Exhibit 2). It is notable that portfolio managers have not reduced equity exposures in line with their recent downgrading of growth expectations. That’s probably explained by fund managers’ continued faith in global monetary conditions. The BofA survey reported that the net number of investors who think that liquidity conditions are positive was the highest since July 2007. Contrarians might choose to focus on the fact that the Global Financial Crisis (GFC) began that very month.
Exhibit 2: Global Fund Manager Survey
Portfolio managers have not reduced equity exposure despite lower growth expectations.
Source: Bank of America Global Fund Manager Survey, as of 14 September 2021. OW = overweight. OW Equities represented by left-hand side (LHS) of chart. Net % Expected Strong Economy represented by right-hand side (RHS) of chart.
It is hard to dispute the view that liquidity conditions in financial markets are highly accommodative; central banks are pumping billions of U.S. dollars into markets every day through asset purchase (QE) programs and by keeping real interest rates unusually low by historic standards.
However, the tide is slowly turning here. Central bank bond purchases are expected to decelerate from $8.5 trillion in 2020 to $2.3 trillion this year and $0.3 trillion in 2022 (see Exhibit 3). The interest-rate cycle also looks set to slowly move higher next year. While the European Central Bank is not expected to raise interest rates until 2023 or 2024, the Bank of England (BoE) is now projected to put in a 15 basis point1 (bps) hike in Q2 2022, followed by a 25 bps hike later in the year. The Federal Reserve (Fed) is also forecast to start raising rates around the end of 2022 once it has wound down its QE program. The risks to these expectations look unusually high, and investors will be playing close attention to near-term BoE and Fed meetings for further clues on how the central banks will approach tapering QE and raising interest rates.
Exhibit 3: Central Bank Asset Purchases
Source: Janus Henderson Investors, Bank of America, as of 9 June 2021. Data based on U.S. Federal Reserve, Bank of England, European Central Bank and Bank of Japan projections. $tn = trillion, USD.
Whistling Past the Graveyard
Corporate debt has been a major beneficiary of central bank actions in recent years, with monetary policy dampening government bond yields and credit spreads.2 In both the investment-grade and high-yield sectors, yields and spreads are close to historic lows. Of course, eurozone yields are notably lower than the U.S. equivalents (Exhibit 4). European “high-yield” debt now yields less than inflation for the first time in history. It is remarkable how corporate bond markets in the major economies have been able to completely shrug off the unfolding debt crisis in China that has pushed yields on high-yield bonds there above 15% recently, as concerns mount about the potential contagion from Chinese property developer Evergrande Group’s financial woes.
While both investment-grade and high-yield debt in the major economies have generally been rewarding assets to own in the post-GFC/QE era, a lot of good news is now in the price. Low yields typically imply low returns from here – low spreads imply low margins for error. Positive growth surprises could push government bond yields higher – negative growth surprises could widen spreads. From this starting point, investors must recognize the bull market path for credit is looking increasingly narrow and the prospects for returns relative to risk are meagre.
Exhibit 4: Credit Spreads at Historic Lows
Source: Janus Henderson Investors, Bloomberg, as of 3 September 2021. Data based on Bloomberg US Corporate Bond Index (USD) and Bloomberg US Corporate High Yield Index (USD).
There Are Alternatives
For investors, alternatives may provide effective solutions to current asset allocation challenges. The range of listed alternative assets available to investors has grown enormously in recent years and market liquidity in these sectors has significantly deepened. At a time when equity inflows could be overly bullish and fixed income offers limited scope for returns, investors may want to consider alternatives for diversification, the potential for attractive income streams and exposure to many emerging areas of secular growth, such as renewable energy, infrastructure and logistics.
1Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
2Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.