Quarterly Market Update
Q&A with Gwynne Shackelford, Chief Investment Strategist of BBVA Compass Global Wealth, and BWS Investment Strategist, Anne-Joëlle Viguier-Galley
In this edition of the BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley review the Brexit vote – its history, the implications, and the outlook for global economies and financial markets.
1. Most investors are familiar with, and maybe even guilty of, the reach for yield. Despite the risks implied in such strategies, are investors still chasing yield?
Today, when many of our clients think of yield, it is actually equity yield that they have in mind, their appetite for dividend-paying stocks being one example. Stocks in the consumer staples, utilities, and telecommunications sectors, along with REITs, have historically been regarded as defensive stocks because the long term stability and dividend-paying aspect of these companies has provided some downside protection during market declines. But the search for yield in the current low interest rate environment has led to such strong flows into this category that valuations have become strained.
No one can predict if these stocks will decline with the first whiff of a rate increase, or even if there will be a rate hike in the conceivable future, but there is valid concern that investors are perhaps overstepping their risk tolerance. Many investors assume they can ride out the volatility as long as the income continues, but our concern is that stated risk- tolerances may be further out on the risk spectrum than many are aware. The price appreciation on defensive equity investments has been attractive relative to returns on other sectors of the market, but we are concerned that the stocks have experienced such a phenomenal run that the traditional defensiveness might not hold, or hold less, in light of higher valuations.
Indeed, investors have become quite conditioned to the “nirvana” of defensive stocks with high payouts. On the face of things, so far in 2016, the strategy appears to be very smart. But, these sectors do not look particularly attractive right now, and the longer investors continue to chase these stocks, the more expensive these companies will become. Because the defensive sectors are more expensive than other sectors relative to their historical mean, should the trend continue, there is the danger of an asset bubble forming.
Perhaps more immediately concerning is the fact that the stocks are increasingly being viewed as bond substitutes, rather than the volatile equities that they are. It is apparent that prices of high-yielding stocks are beginning to trade in line with bonds, rather than on equity fundamentals. If bonds are having a good day, yields are down and prices are up, then so too are those of utilities, telecom, staples, and REITs. The trend reverses when bond yields tick up a bit. But equities are not like bonds; they do not have a maturity date. In terms of duration, it would be like buying a perpetual bond that never matures. The duration on such a vehicle would be extremely long, and the associated risk proportional.
Truth be known, investors do not always associate reaching for equity yield with assuming additional risk. Certainly most investors recognize the relationship between junk bonds and higher yields, but in equities, the relationship between risk and yield is less transparent. A high dividend payout has traditionally been the hallmark of mature companies where the rate of revenue growth has slowed, but the company can still create shareholder value by paying out dividends.
2. How is the reach for yield reflected in stock valuations? Any sector in particular?
Generally, the market is considered to be trading above its long term average valuation and is therefore considered to be “expensive.” However, a look at the sector level reveals that these few sectors, along with energy, are driving the valuation of the market and that other sectors are still reasonably priced.
Valuations of the “defensive” sectors have become more expensive relative to sectors like information technology and healthcare which have historically been more volatile. Going forward, it will depend on the factors driving a market decline whether these stocks will remain defensive, or not. And, should the stock market decline precipitously, will investors who have imprudently loaded up in those sectors lack the tolerance to ride it out, therefore inadvertently fueling a decline?
3. How might these stocks respond during a stock market decline?
That would depend upon the factors driving the decline. Future stock market declines could be precipitated by any number of headwinds. For example, the market could decline if the Fed takes away the punch bowl – raising interest rates with the understanding that the underlying strength of the economy improves. In such a scenario, as rates go up, defensive-sector stocks would decline at a faster pace than other stocks if there is a rotation out of these stocks and into other stocks like financials, IT, consumer discretionary, or healthcare. On the other hand, should the current stock market decline sparked by a global growth slowdown continue, these defensive stocks may retain their defensive characteristics while other sectors decline more sharply.
4. Has the reach for yield been focused mainly on equities, what about fixed income?
No, the search has by no means been confined to equities. The yields on higher quality bonds are low, and spreads over Treasuries are very low. Subsequently, investors have moved into junk bonds lulled by low default rates and the absence of any significant cloud looming on the horizon. But junk bonds act more like an equity proxy than their fixed income brethren and their volatility is much closer to that of an equity than a bond.
We see the same rush into emerging market debt as investors’ clamor for yield has turned their sights outside of the U.S. Currently emerging markets are doing well; prices are rising and the countries have more stable economic outlooks, leading investors to discount the risks associated with the asset class.
5. Recent data indicates that U.S. incomes surged in 2015 to reach almost pre-recession levels. What impact might we expect on interest rates?
If the income surge holds, and if it translates into improving retail sales, increased consumer spending, and housing purchases, then it could become the virtuous cycle that eventually pushes up interest rates through the positive impact on economic activity. But it is far too early to say if it will hold. More and more, extra money in investor pocketbooks is going into healthcare spending, even if only into rising insurance premiums and higher deductibles.
6. What are some alternative strategies for investors in the current environment of pending rate increases?
At the risk of sounding like a public service message, there are no alternative strategies. Alternative strategies cannot be created without taking on an equal, or possibly greater, opposite risk. Investors must understand the risk they assume for the income they seek. Whether adding credit risk by buying junkier bonds, or adding volatility by buying high quality stocks – whatever the source, there is always an additional risk associated with higher income.
The emphasis on yield is making the most vulnerable segment of investors, the older investor at or near retirement who is trying to create an income stream in an income-less world, the most susceptible. For example, in our income-only trusts, the beneficiaries receive only the net income, with no distributions from principal. As yields declined on the bond portion of the portfolio, without reducing the bond allocation, we prudently increased the equity exposure to equity income strategies. We maintained the broad diversification across small-, mid-, and large-cap stocks and international, even while taking an income focus with the large-cap piece. While we were able to support their income streams without sharply increasing the level of risk, the strategy is now reaching a natural conclusion. The strategy has become akin to pushing on a string, there is no place to go to create income without increasing overall risk within the portfolio.
So now conversations increasingly become about reducing income streams. We will not shift bonds to stocks or buy poor quality companies just to maintain an income stream. There is a considerable difference between buying the highest-yielding stock and buying companies with good yields. Some stocks become high yielding because the price drops along with the attractiveness of the respective balance sheets. Other companies increase their dividends each year, and while their stock prices are going up which keeps the yield in check, the company actually has a growing income stream. We favor these companies.
We are not attempting to buy the greatest cash flow solely in today’s terms; we seek to buy a cash flow that can grow for the long term. At this point in the cycle, we believe the best thing to do for our clients is buy good quality stocks that should grow over the long term, and shift into more income-oriented securities in the future as the opportunity presents itself.
Investment managers everywhere are grappling with this challenge. We have moved well beyond efficient frontier portfolio construction; it is now back to the basics of how to avoid assuming excessive risk. Nonetheless, we urge our clients to not give up on bonds, a portfolio’s risk anchor, in order to produce income somewhere else.
BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).