Making sense of current equity and bond pricing

Making sense of current equity and bond pricing

Jihan Diolosa, Associate Director in the UK Institutional team poses questions to our lead multi-asset portfolio managers based on some of the key issues keeping investors awake at night.


 

Current equity and bond pricing

 

Despite equity prices being high, it’s not obvious whether the bull market will continue or if some sort of correction is imminent. We also find ourselves in a low yield environment. What does this imply about the state of the global economy and how is this linked to current and future equity prices?

 

Bond markets – no broad consensus

 

To gain a broad insight into bond market movements, Russell Investments conduct several outlook surveys every quarter about a range of topics such as interest rates, inflation and credit. Select third-party managers (who are specialists in each of those fields) are asked to comment on their outlook.

Our latest surveys were conducted at the end of April.1 In summary, interest rate markets are pricing in a recession whereas credit markets are pricing in a more optimistic view.

 

We asked Head of Fixed Income Research, Adam Smears, what his view is:

 

Head of Fixed Income Research, Adam SmearsWhich side of the bond market do you agree with?

I don’t have a crystal ball, but I know that both sides of the market can’t be right. Investors shouldn’t deploy all their assets off the back of one view, yet if you invest in most fixed income products available today you will find yourself with either a lot of interest rate risk or a lot of credit risk.

How should an investor position their Fixed Income portfolio in such an environment?

The backbone of successful investing is about securing the risk premium, supplementing it with alpha and maximising diversification. However, in this low yielding environment, the focus should be on capturing the risk premia at inefficient spots in the market which offer high Sharpe ratios2. Finding alpha is a struggle in a low yield world, but the distortions created by easy monetary policy do create alpha opportunities and it is very important given its diversification from risk premia.  Lastly finding true diversification in a portfolio is more important than ever. Investors should maximise diversification by accessing risk premia that are powered by differentiated risk factors.

Which instruments would you suggest achieve this?

Shorter duration credit can capture both term and credit risk premium but offer higher Sharpe ratios than traditional investment products. These can be diversified with alpha orientated strategies available in currencies, rates and in the options space. Additionally, some alternative risk premias – such as prepayment risk – are attractive. Prepayment securities are types of mortgage securities offered by US agencies that offer positive yields while benefiting from rising rates.  Such securities are valuable in a world of low yields where valuations are expensive, but sacrificing yield is not attractive. 

Equity markets – have they reached their peak?

Equity markets have been at their all-time high for some time now. Some would argue that expensive equity valuations could continue to be supported.

 

We asked Senior Portfolio Manager of the Russell Investments’ Multi-Asset Growth Strategy, David Vickers, to explain why equity prices are so high:

 

Bond markets are pointing towards recession. Why then, are equity prices so high?David Vickers

Some participants would cite that low bond yields are a reason in and of itself to accept high equity valuations because the Equity Risk Premium is still positive (earnings yield versus bond yield).

Otherwise there is optimism among some that continued economic growth will translate into strong corporate earnings.

Where is there evidence of this?

The US has had a good earnings season recently, and as a result, the market is forecasting 10% US growth for the calendar year 2017. Considering such high forecasts, it’s not surprising that we have seen the market react very favourably.

How are you positioned considering current equity pricing?

I do believe that there are risks looming in global equity markets. There are many geopolitical worries, whether that’s Brexit, Trumpenomics or China, for example. In some markets, such as the US where prices are at all-time highs, I don’t think it’s worth staying exposed given that a price correction could be on the horizon. It may not be now, it may not even be for some time, but it’s still a risk that I don’t want to take given we see the potential rewards as low. 

 

Are losses inevitable?

 

At Russell Investments, we’ve been asking if losses are inevitable given how expensive both equities and bonds have become. The simple answer is no. There are pockets of value to be found across markets, whether you’re an equity, bond or multi-asset investor. Dynamic portfolio management and an awareness of changing market conditions are key to navigating environments like the one we find ourselves in today.

 


Related Posts
Fixed Income Survey Results: Spotlight on Local EMD, Rates & Credit Spreads


Jihan Diolosa, Associate Director, UK Institutional

Jihan Diolosa, Associate Director, UK Institutional

1The survey was conducted prior to the US Federal Reserve’s recent interest rate rise on Thursday 15 June 2017.
2The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.

 

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