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Five insights in five minutes

Five in Five: record stocks, HY, Japan, Goldilocks inflation, payrolls
10 September 2021

    Record stock prices

    Labour Day is done, summer is over, the white jeans are back in the drawer. So here is a note to cheer up our American readers as well as anyone invested in US equities (and that should be all of you). Our strategy team has just calculated that three-month returns for the S&P 500 have clocked up 320 days without being negative. Apart from a couple of times mid last century, that is a record since the Great Depression, as you can see in the bottom chart below. But it is the red line you should pin above the bed, email to clients, and recall whenever markets panic. It shows the enduring triumph of human ingenuity, productivity and resilience – measured in the value of US companies. Not two world wars, oil crises, disruptive technological change, countless financial meltdowns, terrorism, or a global pandemic have altered a steady upward trajectory. And neither will whichever risks are trendy to talk about now. Buy equities on a dip if you can, or buy them high. It doesn’t matter in the end.

    Ways to play: US equities

    Record stock prices  

    High yield oxymoron

    Another ‘through the looking glass’ moment, as real yields on European sub-investment grade bonds drop into negative territory. Think about that for a minute. Investors are actually paying to lend money to low quality corporates! To be sure, the hoovering up of a third of investment grade bonds by the European Central Bank has forced up demand for higher-yield securities. But low macro volatility and risk free rates are depressing real yields the world over – even 80 per cent of American high yield credits have an effective yield below inflation. Nevertheless, the asset class is attracting investors who see even worse real yields elsewhere – in bunds, for example. And if higher inflation is transitory, real yields will soon become positive again. Meanwhile, inflation is good for heavily indebted issuers (assuming the ECB doesn’t raise rates) and a strong recovery also lowers default risk. Some downgraded companies (fallen angels) could even get their investment grade ratings back. Negative real yields, therefore, are not as fantastical a proposition as they seem.

    Ways to play: European high yield, global high yield

    High yield oxymoron  

    Japan equities

    One year into Warren Buffett’s venture into Japanese equities and the five trading firms Berkshire bought into have risen by a third on average, five per cent ahead of the Topix benchmark. The market is indeed a hunting ground for resilient, high quality companies at attractive prices – just Warren’s thing. In fact, as the chart below indicates, the Japanese exchange boasts the second largest number of so-called ‘net-net’ stocks globally. These are deeply undervalued names on a balance sheet-based ratio first used by Buffett’s intellectual father, the famed Benjamin Graham. To be fair, there are nerdy accounting reasons why Japan always looks cheap versus peers on book value comparisons. And poor historical returns leave foreign investors hard to impress. They have net sold 100 billion dollars’ worth of Japanese stocks over the past half-decade. But for how much longer the world’s third largest economy can have an underperforming stock market, 25 per cent cheaper than America’s on forward earnings, and three quarters cheaper on a book basis, is worth pondering.

    Ways to play: Japanese equities

    Japan equities  

    Goldilocks inflation

    Our multi-asset team has done some number crunching to see how portfolios have performed under different inflation environments historically. As it turns out, medium inflation levels (around two per cent) proved to be the sweet spot for well-diversified portfolios since the turn of the century, delivering higher real returns at lower volatility. Being inquisitive, much like Goldilocks herself, the analysis was extended back another century. This limited data to the S&P 500 and ten year treasuries, but nonetheless the same story plays out – the strongest risk adjusted returns for US stocks occurred under periods of medium inflation, and came with near-zero correlation to treasuries. Today, our strategists forecast longer term inflation to land right around the not too hot, not too cold, two per cent level. Although some bonds face near-term headwinds coming off rock bottom yields, there doesn’t appear to be a reason to fear inflation with a diversified portfolio.

    Ways to play: Multi-asset, global equities, global fixed income

    Goldilocks inflation  

    Shock US payrolls

    Were you bamboozled by last Friday’s payrolls number? So were economists. Arguably the most analysed data release in the world came in at 235,000 for August – miles short of the 730,000 consensus and even the gloomiest of estimates. Investors were also flummoxed. Ten-year bond yields, for example, immediately dropped from 1.29 to 1.26 per cent before closing the day higher at 1.32 per cent. Global equities, similarly, sold-off before making record highs once again by the end of the day. To be fair, the payrolls data were open to interpretation. Half of the drop was due to weakness in delta variant-sensitive accommodation and food jobs, while July’s reading was revised upward at the same time. Indeed, the average final revision to payrolls numbers this year is above 100,000 – so most initial headlines should be ignored. That said, the report plays to the ‘lower for longer’ crowd, and hence real yields remain stubbornly depressed (see HY note above). As our strategists point out, this together with central bank interventions has produced a kink in their expected return versus risk line, as can be seen below.

    Ways to play: US and global equities, global fixed income

    Shock US payrolls


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