CIO warns that while stocks melt higher, declining bond yields suggest more caution is required
While there have been fluctuations, markets appear relatively stress free given the backdrop of an economic reopening and the Delta variant.
In July, the S&P 500 managed to increase 2.4%, while the S&P/TSX recorded a 0.8% gain. Canadian and U.S. bond yields continued to grind lower, however, ending the month at 1.22% and 1.20%, respectively.
Rob Edel, CIO at Nicola Wealth, said a remarkable characteristic about this market is that it doesn't display any real concerns about anything, be it the pandemic, extreme weather events, non-transitory inflation or people returning to work. He said: “Stocks continue to melt higher, despite declining bond yields appearing to signal that more caution may be required.”
He posed the question: what is the market’s current reality? Seemingly, there is no end to this bull market. Goldman Sachs recently increased their year-end target for the S&P 500, leaving room for stocks to drift another 7% higher before ending the year with a nice 25% gain. Even next year, Goldman sees the rally continuing, though they are forecasting only a 4% gain.
Edel said: “Perhaps the harshest reality of this market is that this is what ‘good’ looks like. Is this as good as it gets? Current valuations are high, not just in stocks but in all asset classes, which historically has meant that future returns will be more challenging.”
He pointed to asset manager GMO, which believes the only asset class set to deliver positive real returns over the next seven years are emerging market value stocks. GMO sees U.S. stocks as the biggest loser, but even cash is forecasted to lose 1% a year after inflation over the next seven years.
“Valuation is a better predictor of returns over the longer term, but not so great over the short term,” Edel added. “In the short term, expensive markets tend to get more expensive, until they eventually correct and get a whole lot cheaper. It is also worth mentioning that these forecasts are for the broader market benchmarks. Individual stocks, sectors, and geographies can do much better, or they can do worse. It can be misleading to draw conclusions based on broad benchmarks if this is not how you invest.”
Taking a look at fixed income
Perhaps the biggest struggler in this “harsh reality” is fixed income. Edel beleives there are essentially three main return generators: rates (meaning yields decline driving bond prices up), coupon, and credit. And none of these look very attractive right now.
Since current yields are already so low, there is not much room for rates to decline further to push bond prices higher. A more likely scenario, in Nicola’s opinion, is an increase in yields which, depending on the term of the bond, would be much more problematic. JP Morgan estimates a parallel 1% shift in interest rates would result in 10-year bonds falling nearly 9% and 30-year bonds dropping just over 19% in price.
Edel said: “The risk/return trade-off for government bonds is currently very poor due to a low coupon rate, and more downside than upside room for future movements in price. While it is true that coming into 2021 bonds had outperformed stocks over the last two decades, we find it hard to believe this will continue to be the case this decade. The prospects from high-yield, or credit, are better, but still far from ideal.”
Where else to look then? Private debt is an attractive alternative to public markets. And while the lack of liquidity can be an issue for some investors, in times of market stress effective liquidity becomes scarce, even in the public markets.
Edel explained: “In addition to an illiquidity premium, private credit investors can also expect to earn a complexity and uncertainty premium for lending to markets with less opacity where information is not as widely disseminated as in the public markets.”
He added: “How ‘harsh’ is our current reality and is this as good as it’s going to get? Fixed income appears to face some headwinds, but equities, alternative strategies, and credit still appear to present attractive opportunities.