Aside from a relentless barrage of deteriorating geopolitical updates almost on a daily basis, which have led even the “very serious thinkers” to pull up comparisons to the days just before World War I, it has been smooth sailing for global capital “markets” which merely continue to follow the path of least central bank balance sheet resistance. It is this relentless melt up which has seen what was once a market and is has for the past 5 years become a policy vehicle to boost confidence (for whom, it is unclear: the vast majority of the population no longer cares what rigged stocks do, as for the trickle down wealth effect, 5 years of deteriorating real incomes for the middle class have promptly put an end to that fable) alongside a slow-motion LBO of the entire S&P 500, as companies repurchase trillions of their shares using ultra-cheap credit, bask in the glow of complacency so vast even the Fed is openly warning against it.
It is in this context that at least one bank, has voiced an alarm against pervasive, record complacency (that no matter how bad things get, the Fed will step in a bail everyone out, in fact the worse things get the better) after UBS’ Stephane Deo released a paper titled “We are worried. We reduce risk – for now.”
The key excerpts from the report:
Firstly we are concerned about valuations. We show that equity markets are stretched (e.g., more than 80% of the S&P rally since last year is due to re-rating), but we also find that the fixed income market has become quite rich (we have been overweight European peripherals for more than a year on valuation grounds, we show that this argument no longer holds), and the same is true of the credit market. Second because capital has been flowing rapidly into risky assets, we document that argument and here too find evidence that the market might be ahead of itself. We read the market reaction last week to the Portuguese news as a sign that the market is indeed too complacent and could correct rapidly.
Why we are worried
As we wrote in the previous section we remain constructive on risky assets over the medium term. However we think it is now time to scale down risk. The canary in the coalmine this time was Portuguese: The issue last week with Banco Espírito Santo (BES) had large impact on a variety of asset classes over the world. This includes other Portuguese banks, but also wider range of asset like the all SX7E index, the sovereign spreads in Europe and it even had an impact on the VIX. The various reactions from these asset classes seem large unless the BES event hides something much bigger and is the start of a new systemic crisis. This is not our central case scenario. In a recent note Bosco Ojeda explains that genuine improvements have been accomplished in peripheral Europe and the return of systemic risk is unlikely. Rather we think the event tells us a story about market positioning and market pricing: we think the market is stretched (more on that immediately below). If this is true, the market is already pricing most of the potential good news and is prone to react to bad news.
The pricing argument
Let’s first look at pricing. We have argued that all the major stock markets are close to fair value. This is the case if we look for e.g. at our trend adjusted P/E, or if we look at our equity risk premium index. What is true though is that the recent momentum in markets is difficult to justify. The chart below shows that our economic surprise index has been very highly correlated with the S&P 500 until the beginning of last year. Since then the market has continued his rally with little fundamental improvement to support it. This divergence is becoming uncomfortably large.
And indeed, as we go to press, we get a helping hand from the Fed himself. The Fed said in a report that “valuation metrics in some sectors do appear substantially stretched, particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”
We also believe that the credit market is reaching tight levels. There are two additional characteristics of the credit market that worry us. First the quality of issuance has deteriorated as evidenced by a number of metrics: for instance the average rating of issuers has declined, the number of first-time issuers has increased, the number of payment in kind (PIK) clauses has surged, etc… Second the ratio between primary market issuance and secondary market daily turnover has greatly deteriorated, which is also a worrying sign. We have highlighted repeatedly in the past that the lack of liquidity in this market is a key issue for us and that it could prompt a sharp market over-adjustment.
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Risk premium is the extra return investors demand to hold a risky asset above the return of a risk-free asset. Although excess return varies widely over time, particularly for equity, risk premium tends to be mean-reverting. This can either be estimated using expected cash flows as the rate that has to be added to the discount rate to back out current market prices. Or more simply we can look at historic excess returns.
In Figure 14 we can see the long-term excess returns of the assets in our portfolio against the excess return over the last year. The data have been sorted by return over the last year, and it is clear that the last year has been highly atypical. Equity, credit and listed real estate have had excess returns far above their long-term averages particularly in the UK and Europe. At the bottom of the bar graph volatility has been very low and the mid-term VIX futures index (SPVXMTR) has been losing value more quickly than usual.
It is interesting that some assets are broadly in line with their long-term average, such as US listed real estate, US high yield credit, and US Treasuries. The excess return of Asian listed real estate is actually below its long-term average. As a trading signal risk premium is very unreliable because it gives no sense of timing. But given the returns over the last year risk premia are certainly unfavourable.