Global Perspectives: Silver lining for equities and bonds in a cloudy market

Adam Hetts: Welcome back to Global Perspectives. And today, we’re talking about stocks and bonds. Thanks to Greg Wilensky and Jeremiah Buckley for joining. Greg is a Fixed Income Portfolio Manager and Jeremiah is an Equity Portfolio Manager here at Janus Henderson. And Greg and Jeremiah work together to co-manage several multi-asset funds here at Janus Henderson. So we’re going to get a timely update across both U.S. equities and fixed income. So Jeremiah, let’s jump right into equities. The S&P hit that 20% bear market threshold earlier this year and I think at that point, more investors are arguing that most of the bad news must be priced in. So what do you think? Is most of the bad news priced in? And just what got us to that 20% threshold between multiple contraction or earnings revisions or whatever other risks that were out there? Can you just get us up to speed?

Jeremiah Buckley: Yes, sure. So, most of the contraction so far this year has been multiple contraction. We have seen … so, we began the year with the expectation that S&P 500 earnings would grow double digits. And that was based on the potential from the recovery from the pandemic, as well as consumer and corporate balance sheets being extremely strong and the expectation that they would both continue to spend and invest, which would be good for economic growth.

Most of that 20% decline in the first half of the year we attribute to the change in interest rates and the multiple contraction. Earnings estimates for the S&P 500 have not changed that much so far this year and we expect that there will continue to be earnings growth in the second half of the year.

Now we have come down a little bit from that double-digit growth because there have been a number of factors that have impacted earnings, especially for multinationals and manufacturers. Because we’ve seen higher interest rates, we’ve seen higher commodity prices than we had at the beginning of the year, particularly in energy, and we’ve also seen a much stronger dollar than we had at the beginning of the year.

On the other hand, as a result of those higher commodity prices, the mix of S&P 500 earnings has also shifted. And so while we’ve seen some areas of the market have lowered earnings expectations, commodity-oriented companies and energy sector companies have seen their earnings estimates go up and offset some of that. On the downside, we’ve also seen some companies like retailers who have experienced higher-than-expected markdowns because we’ve had this faster-than-expected shift back to consumer spending on services as opposed to goods, which benefited during the pandemic. We’ve seen some of those retailers also have to reduce their earnings assumptions for the year. But as I said, as a whole, overall earnings estimates have been relatively stable.

Now, as we look into the second half, we still believe that there is the prospect for reasonable earnings growth for companies in the indices. And that’s based on, one, we continue to have a strong labor market, and so consumers continue to be able to have the opportunity to spend. And we are starting to get to a point where a lot of the companies who have faced these cost pressures, whether it be the strong dollar or commodity price inflation, are passing along those prices to their customers and are starting to realize those pricing benefits, which are offsetting that cost inflation and improving their margins. And so we continue to believe that we will see earnings growth here in the second half of the year on a year-by-year basis as well as a sequential basis to the first half. And we do believe that some of those same factors will start to benefit and drive some earnings growth in the first half of 2023 as well.

Hetts: Thanks, that makes sense. So we had this multiple contraction, i.e., the PEs reduced. And it was really, to your point, the PE that was getting reduced, the price people were willing to pay for earnings, even though earnings weren’t really changing because interest rates got increased, money got more expensive. So people were willing to pay less for the same earnings. So you’re saying, going forward, we’re still going to have earnings growth. The composition, or wherever we’re seeing strength in earnings, is shifting across different sectors and industries, as you explained. So in the second half of the year, what do you think about these calls for, like, the profit recession and these big drops in earnings? When you’re talking about earnings growth, are you seeing a downward revision compared to current earnings growth projections, or just a shift in composition?

Buckley: So it’s a little bit of both. So we have seen some reduction in the overall level of earnings expectations due to some of the reasons that I pointed out. But we believe that there still will be year-over-year growth in earnings in the second half of the year and going into the first half of next year. And as far as what that means for the market, we believe given the multiple contraction that we’ve seen so far this year, we believe the equity risk premium is much closer to a more normal level. It’s still on the high end relative to kind of recent history. But we believe it’s at a more normal and rational level than it was historically. And so as far as the equity market outlook, we think that equity markets will trade more closely to what the earnings outlook ends up being and earnings growth driving that outlook going forward than we saw in the first half of the year, which was carried by multiple contraction.

Hetts: That’s helpful. So a lot of focus on earnings growth going forward. And compared to the last few years, a lot of sources of a lot of dispersion going forward based on the composition of earnings, a lot of the macro shifts that we’re seeing in the environment. So then on that note, specifically on growth equities where we’ve had this massive U.S. tech or FANG leadership, whatever you want to call it, over the last so many years, now we’re sort of in this bear market still for growth investing. So what do you think that next generation of growth equity leadership looks like from here? Is it the FANGs taking over again? Or is it a different style of growth investing that’s going to lead?

Buckley: Yes, so I’d note first that the first half of 2022 was one of the worst relative periods of performance for growth stocks relative to value stocks over the last 10 years. We don’t believe that this disparity will continue as we believe stock prices over time are driven by long-term sustainable earnings growth and that the companies that are able to grow those earnings over time will benefit. Now, as you point out, the growth leaders within the market do change over time. We continue to have conviction, though, in a number of themes that we think will drive earnings growth going forward.

We believe companies using technology to improve data analytics around their customer relationships as well as product performance will continue to gain share and become more efficient over time. We believe that companies with strong balance sheets and consistent cash flows who are able to invest through volatile macroeconomic periods like the one that we are in will also position themselves for faster relative growth once we get to a more normal investment environment.

So we believe that some of the winners that have driven growth in the market over the last couple of years will continue to benefit from those secular themes. But there will also be other companies who are investing in new areas of the economy that will drive some of that growth going forward. But we think, across the board, it’s those companies, like I said, that have been able to continue to invest through difficult times as well as companies that are using technology to improve their products and services that will be the leaders going forward.

Hetts: Alright, thanks. And Greg, moving over to the fixed income side of things, I think we’ll start, instead of earnings, we can focus on credit spreads comparing Treasuries to corporates. What do you think about the current level of spreads versus where they’re likely to go as the slowdown supposedly continues and maybe even turns into a recession?

Wilensky: Well, that’s going to be kind of the critical question here. When we talk about the slowdown, I think we all believe growth will be slowing from where it was in 2021. But do we get a soft landing? Do we get, you know, below-trend growth, something just slightly positive? Or do we actually move into a recession? And that will clearly have a big impact on where spreads can evolve over time. From a good news perspective, we at least have spreads now at a level that’s significantly above where we were at the end of 2021. At that point, spreads on both investment grade and corporate bonds were down more kind of near their tenth percentiles. And as we’ve reached the middle of this year and spreads have backed up a lot, depending on the day and depending on the index, we’re much closer to kind of long-term average numbers. So that at least put us in a much better starting point.

But as we look forward and see certainly the risks that growth is more likely to be below trend, i.e., we’re not going to get that beautiful soft landing that we would all frankly hope for and we still are hoping for, and we’re more likely to be dealing with kind of a well below trend growth or even negative growth going forward. What we’ve done is we’ve spent a lot of time looking back at history and looking at where spreads have gotten in other periods of stress. And frankly, even if we exclude the most stressful events that we’ve experienced in the last 20 years, so if we exclude the Global Financial Crisis and what we saw during the pandemic, the levels of spreads we see now compared to the average of those other stress events, whether they were recessions or just concerns that we were going into recessions, spreads are still a fair bit below those levels.

So for some numbers right now, the spread on corporate investment-grade bonds is around 141 basis points, or 1.4% over Treasuries. And that’s about a level that’s about 66% of the average of these other stress events that we’ve seen since the beginning of the century, excluding the GFC and the COVID pandemic. So when we look at that and we think about it, we think there is frankly, potentially room for spreads to widen as the market comes to grips with possibly a view of a rising probability that we go into a very slow growth or recessionary period. Same thing is true on the high yield side as well, where current spreads are about 440 basis points versus kind of an average excluding those extreme events of over 800 basis points, or 8%.

Hetts: And for high yield, what percentile would that put us in if the corporate spreads, the investment grade spreads, are at the 66th percentile?

Wilensky: About the 53% of the averages of those other peak events. So we are close to kind of long-term averages, but this other average I’m talking about is what is the average during these stressful time periods.

Hetts: Yes, I knew spreads weren’t pricing in a whole lot of recession risk. That’s even less than I realized. I like that you exclude the Global Financial Crisis and the COVID sell-off as the extreme like crises with the premise that we’re going into a slowing growth/recessionary environment that’s supposed to be this shallower, milder recession. So compared to those, it’s especially surprising that you could say corporate investment grade spreads are only kind of in the 66th percentile. And then high yield is still just kind of average compared to these other more recessionary environments.

Wilensky: Yes, and part of that is we have seen, since the end of the second quarter, a very substantial rally in spread. So we were a bit closer to those kind of previous stress event levels at the end of June, but we’ve seen a very strong rally during this quarter just like we’ve seen a very strong rally in equity prices in the last month as well. So that’s something that you’ve seen happen on both sides, is both tied to fixed income and equity risk product as rates fell and there was a little bit of a view that maybe the Fed would not have to be raising rates as much. So I think that was a driver of both of these.

Hetts: So then sticking with high yield of current spread levels around 440 basis points, and you’re talking about the actual kind of typical recessionary spreads more at the 800-basis points level. So as we supposedly travel from 440 to 800, at which point does it start getting very attractive to buy into those spreads versus right now, where it feels like maybe being very cautiously optimistic and waiting a bit longer?

Wilensky: Yes, so I would say I’m not necessarily saying we’re going to 880. I don’t know that we’re necessarily saying we have to be pricing all of that in. It’s just as we’re looking forward, you know, we’re not looking in the short run at spreads being very attractive. I would say on a longer holding period, a lot of this has to do with your holding period. If you’re asking me do I feel comfortable at these kind of spread levels that are closer to long-term averages of holding for a, you know, a long period of time? Given the fact that fundamentals, because we’re always thinking about valuations and fundamentals and thinking about how they trade off against each other. And with the spread levels, let’s call it closer to long-term averages and, frankly, the underlying fundamentals, whether we think about it, the fundamentals of the economy, which are actually reasonably strong, and when we think about the amount of defaults or losses that we’re likely to have, we think those, even though they’ll be getting higher than they are now, they’re starting from basically all-time lows. Even if we go into a mild recession, we expect the defaults to be well below the average of previous recessions. So that provides a good backdrop for the long run.

That said, in the short run, we would be looking for spreads to increase from here before we got, frankly, more positive on them, although that’s always going to be done against the contrast of how our view of the fundamentals are evolving. If we start to see things like inflation coming down rapidly while growth moves down more slowly, well, that’s going to make us more positive on our view on owning high-yield bonds and IG corporate bonds, and when we’re going to want to get in. So it’s always going to be the play-off between the fundamentals and valuations.

Hetts: Yes, I think you raise a few good points there, or at least reminders for some folks, is that the mild recession, mild being the operative word because we’re going to have such a great economic baseline underneath all this fear and slowdown and concerns. And so the spreads being a relative measure, so spreads are 440. An absolute term, we’re talking, what? 6%, 7% yields, which people have been dreaming about for a while and you can finally get those in the market. And if fundamentals are relatively strong and even medium time horizon, this is still a good enough time to start considering some of that exposure, as to your point, which makes sense.

Wilensky: Absolutely. Especially when you think about with defaults running kind of well below historical averages, below 2% type numbers. And when you factor in things like recoveries, if you’re earning a 7% yield and defaults are less than 2%, you kind of put that through and think about recoveries, that’s still generating a lot of income. Frankly, a lot more income than we were seeing a year ago when you think about where both treasury yields and spreads were. So there are positives and a lot has to do with your timeframe.

Hetts: OK, that’s great. And just to clarify, I think I was saying 800, but you said 880 is the recessionary kind of spread level.

Wilensky: 880 was the, sorry … 838 was the average of five previous kind of peak levels. And it’s important to remember you rarely stay at those peak levels. These are the peak-level, like the worst day during any of those events. And it’s very difficult … let’s put it that way, to try to say you’re going to get in and decide when you’re at the peak and to actually be able to buy a significant amount of bonds there. So I think that’s why we’re not looking for 100% of those numbers as kind of the criteria for wanting to get much more positive on those sectors.

Hetts: Yes, it’s tough to buy the bottom. A little bit easier to buy a dip, though. So, Jeremiah, back to equities. So of course lurking beneath all this conversation is this year’s historically high inflation. So how would you describe your life as an equity investor this year while inflation has been in the high single digits in the U.S.?

Buckley: Yes, so there are two factors that impact equities when we’re in a high inflationary environment like this. So first and foremost, so far this year, has been the impact of multiples. So as interest rates rise, we see multiple contraction on the equity side as equities are longer duration assets. And so they’re certainly impacted by that, of course. But the second piece as Greg pointed out is fundamentals. And what we look at and what I’ve talked about is earnings for equities, what happens in a high inflationary environment is that companies face higher cost pressure which impacts their margins. But the highest quality companies who have a reasonable amount of control, their business are able to enact price increases to offset those cost pressures. And so we end up with higher nominal earnings, which ends up being good for equities and offsets some of that valuation degradation that we see.

And the positive to that, too, is that most of the time, price increases for companies are sticky. And so when we get to a point where cost pressures either level out or actually reverse, companies generally are able to keep prices where they are and see margin improvement as a result of cost coming down. And so we’re trying to balance those two pieces. So obviously, you know, we came into the year expecting interest rates would go up, but maybe not as fast as they have. And we expected some multiple expansion, but it’s been a lot faster and a lot more severe than we anticipated. And so it’s balancing that potential for valuation impact versus the actual growth in nominal earnings that we see for companies that have the ability to pass along price to their customers.

Hetts: And do you expect that trend to play out for a while? In other words, so far year-to-date, like these higher-quality companies with wider margins and stronger pricing power, do you feel like that’s been priced in and they’ve kind of received already a little bit more interest and a little more resilience in the face of inflation? Or do you feel like it’s going to take a while as that kind of inflation percolates through the system in those companies will continue to outperform for a while?

Buckley: Yes, so two pieces. So I think we started to see some of that more so in the second quarter, where we started to see some better … when we saw the most severe market declines, the higher-quality companies started to perform better on a relative basis. They were still obviously down with the rest of the market, but we did start to see some of that and we would argue that the price increases for these companies still aren’t fully reflected. You know, they usually take their time to put in increases to make sure that the commodity costs are sustainable.

They have to go through a process of explaining it to customers, and so they usually lag with the price increases, and that’s why we’ve seen, you know, more margin degradation in the first half of the year. And part of our belief that earnings in the second half of the year will actually grow year over year as a lot of that pricing is starting to be fully realized now, and that also should continue into the first half of 2023. And so we’ll start to see the catchup of some of that pricing that has lagged, the cost increases. And this comes at a time where we’re starting to see commodities level out. You’ve seen some commodity prices come down. We certainly don’t expect to see any wage inflation moderation, you know, anytime soon. And so that will all balance out. And that helps kind of inform our view of what second-half earnings growth will look like for the companies that we’re following.

Hetts: OK, thanks. Yes, I guess a silver lining of sorts, loosely speaking, as far as inflation and equity returns. And I guess, Greg, similarly, maybe a bit of a silver lining with all the inflation risk is that core bond rates have skyrocketed this year. So since you already talked about spreads as far as just rates go with the U.S. 10-year in the high 2% range right now, is it safe to say core fixed income investing has gotten a little bit easier than it was a year ago for you?

Wilensky: Easier is a weird way to frame things when you think about the good and bad. I think from a positive, from an absolute positive perspective, the fact that we’re looking at yields, let’s say, on the Aggregate Index at the end of June at 3.7%, which is, frankly, the highest level we’ve seen in the last decade, that obviously creates a, you know, a much better outlook for longer-term intermediate to longer-term returns. Because certainly when you’re talking about fixed income over the intermediate or longer-term returns, the starting yield is a pretty good indication, especially over an investment grade portfolio, of the return. So that is a positive. That means it’s going to be able, over a longer period of time, to generate that kind of income.

I also think, thinking about as we very much do, whether we’re talking about our standalone fixed income portfolios, or the role of fixed income within a balanced strategy like the ones that we manage here, that we think of fixed income and its ability to provide a ballast or an offset to potential volatility in the equity market. And with yields at that kind of higher level, I think there’s, you know, it’s much more likely for fixed income to go back to be playing that traditional offset role. So that’s certainly a positive.

On the other side, I will say as an active, just broadly speaking, as an active fixed income manager and active manager in general, volatility we actually look at as being somewhat of a good thing. It creates dislocations in markets and it creates opportunities for us even though it has been a bit of what’s called a stressful year. Although it seems like it’s been that way for the last few years in the world.

With a yield, you know, Treasury yield higher, I think that provides a bit more of a tailwind going forward. And not only are we thinking about where the nominal yields are, where you talked about, you know, high 2s, around 3% on Treasuries, but also what’s been going on and what we call real yield, which can be approximated by using the yield on TIPS or Treasury Inflation Protected Securities. And this is thinking about the yield that with a TIPS security, you’ll earn that plus whatever inflation turns out to be. And at the beginning of this year, those real yields had gotten basically to all-time lows. You know, I’ve been investing in the sector since the late ‘90s and we saw real yields get down to below -1%. And they’re now back up on 10-year TIPS in, you know, about 35 basis points now. It’s a tiny bit below kind of the post-GFC average, but right in the realm of where those had been. So I think that provides a much better backdrop for returns going forward. And again, the ability of fixed income bonds to act as kind of a shock absorber.

Hetts: So on that note, turning all this together, you two work as a team and you’re both wrestling with all these risks, the slowing growth, inflation, the interest rate volatility. So when you think about the right mix of stocks for growth versus bonds for their various roles of income and capital protection like you mentioned, how have you two approached how to adjust the mix during the volatility we saw this year? And what are your thoughts going forward on what the best version of a 60/40 is going to look like?

Buckley: Want me to start? I’ll start. So, going into the year, we had the expectation as a team that interest rates would rise. We thought at the time that it would be a gradual and moderate level of increases over time, getting back to a more normal level of Treasury yields and bond yields. As a result of that, we still had a bullish forecast for earnings growth for equities. And so at the time, we favored equities over fixed income based on our thought that even though, with rising interest rates, we would see some degradation in the equity multiple, the earnings growth would more than offset that enough so that returns in equities were likely to be better than in fixed income.

Things changed quickly at the beginning of the year given some of the external events and more severe inflation, which led to interest rates rising faster and more materially than we would have anticipated at the beginning of the year. As a result of that, our risk/reward trade-off between equities and bonds started to change and our view became more neutral between the two asset classes.

As things have further escalated through the second quarter of the year, our stance continued to evolve as bond yields became more attractive and concerns around equity growth became more acute. And so at this point, and more recently, we believe that the risk/reward is a bit more favorable for bond yields relative to a more neutral stance that we’ve had in the past. But we continue to evaluate the growth opportunities and the opportunities that the market presents us to continue to evolve that positioning.

Wilensky: We’re having regular debate and conversation, and the insights that we’re able to share between the two teams about what we see going on in our individual market is something that I think makes us, frankly, both better portfolio managers, even on the single asset class portfolios we manage, and then it really comes together when we think about how to build a portfolio that balances both equities and fixed income. It’s still this underlying view that research drives everything and how we’re trying to compare both on the fixed income and on the equity side, what’s going on from a fundamental perspective, and what are we seeing from a valuation perspective? And if we come together and we debate this, and we’ll adjust the portfolio, we will adjust our asset allocations over time based on the opportunities we’re seeing. And like I noted before, you know, volatility in the market often creates some great opportunities as well.

Hetts: Yes, I think we laid out plenty of silver linings given how pessimistic the news has been year to date this year. So it’s good to hear. Thanks, guys, for doing this. Anything we missed that you wanted to cover?

Buckley: I don’t think so.

Wilensky: All good. Thank you very much for having us.

Hetts: OK. Thanks, Greg and Jeremiah, again. And thanks to our listeners for joining. If you haven’t already, you can find more Global Perspectives on Spotify or iTunes or wherever you listen. And of course, check out the Insights section of the Janus Henderson website for more of our views. Thanks again and see you next time.

 

Investing involves market risk; principal loss is possible. Equity and fixed income securities are subject to various risks including, but not limited to, market risk, credit risk and interest rate risk.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.

Inflation-linked bonds feature adjustments to principal based on inflation rates. They typically have lower yields than conventional fixed-rate bonds and decline in price when real interest rates rise.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

S&P 500^® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.