Key Takeaways
- During 2022, we witnessed a paradigm shift in markets. Investors may want to think twice before “buying the dip” in equities due to the new environment and valuation levels.
- Given the outlook, we believe investors should consider tactically substituting some equity risk with credit risk.
- Doing this should make one’s portfolio more resilient in an uncertain environment for risk assets. It also enables investors to take advantage of the more attractive income/yield offered by credit compared to equities.
Recession Expectations
Today, many market participants are anticipating a short and shallow recession, followed by a reduction in interest rates in a few quarters’ time. This is captured by the inverted
shape of the yield curve whereby short-term interest rates are a lot higher than longer-term rates. After a decade-long bull market in stocks, investors also seem to be banking on a
near-term rebound in the equity market. The sizeable equity price rally witnessed from early October to early December 2022 suggests that the “buy the dip” mentality is alive and well. Historically, an equity price surge has indeed often
occurred in the first two years following a recession’s end (the exception being 2001 - 2003). However, we believe more caution is warranted at this juncture, and investors are better served by taking a more conservative stance.
Paradigm Shift
We believe there was a paradigm shift in 2022, marking a decisive break from the previous decade. More specifically, in view of the extraordinary course of monetary policy experienced over the past several years, investors really should be
asking whether the market is correct in hoping for the traditional recession playbook. Given high global debt levels, deglobalization, decarbonization, demographics, geopolitics, and the likelihood of more frequent supply shocks, there
are strong reasons to suggest that the world has experienced a major regime change. At the very least, it seems clear that the long period of low inflation, suppressed volatility, and easy financial conditions, is over.
Elevated volatility and macro uncertainty should raise real concern regarding the likely future performance of equity-tilted portfolios. Looking back, there is no doubt that monetary and liquidity conditions have been incredibly favourable
for equity investors in both public and private markets and especially for those strategies that buy assets using leverage. But while central banks are likely to moderate the pace of interest rate increases, we do not expect to see a return to stimulative policies. The probability of rates being ‘higher for longer’ reflects a concern that the worst outcome for the US economy would likely come from allowing inflationary expectations to become entrenched. Learning
the lesson from Paul Volcker in the 1980s, central bankers have signaled their determination to make sure they decisively defeat inflation before loosening the reins on policy.
Understanding Valuations
Although equity markets have corrected meaningfully, especially in the US, valuations are still far from compelling by historical standards. Equities have repriced lower in response to higher interest rates.
However, have equity valuations fallen enough given the outlook for a recession and economic slowdown?
In uncertain times, it is important to pay attention to valuations as an anchor. Studies that look at valuations today versus long-term relationships suggest that equities may still be trading above fair value. An example of this kind of analysis
is shown below, taken from US consulting firm Research Affiliates. They find that, even after the market correction of 2022, many equity markets are trading 10-20% above long-term fair value levels.
This overvaluation may stem from overly optimistic expectations around corporate profits. While equity prices have factored in higher interest rates, we do not believe investors have adequately factored in the profits/earnings impact of a slower economy. This is particularly due to the evolving global economic downturn and the plethora of cyclical and structural headwinds
(labour market tightness, inflation, increased cost of financing, US dollar strength, deglobalization and onshoring, rising regulatory burdens, etc.). Aggregate corporate profit margins are currently well above the long-term average (approx. two standard deviations). Surely any noticeable reversion toward the mean in profits would precipitate another leg-down for equities, and history suggests that the third down leg is often the most severe.
Equity Risk vs. Credit Risk
With these considerations in mind, we believe investors should consider substituting some equity risk with credit risk. As discussed above, we believe there has been a regime shift in markets and that the coming period will be characterized by more volatility and macroeconomic uncertainty. Looking at valuations, we also believe there may be more weakness in store for the equity markets. With this in mind, we think allocators with the flexibility to adjust portfolio weights may want to tactically substitute some equity risk for credit risk.
We see two benefits investors can obtain from doing this:
- Investors would benefit from having a portfolio with more resilience/downside protection given the uncertain market outlook.
- It enables investors to take advantage of a significant dislocation between the relative attractiveness of bond yields versus equity earnings yields.
Regarding the first benefit, consider that - compared to equity investments - investing in fixed income provides more senior positioning in a company’s capital structure, more covenant protections, and consistent income. These characteristics
help explain why fixed income tends to be more resilient in periods of stress and provides downside protection for a balanced portfolio. Moreover, fixed income tends to bounce back quicker than equities when markets stabilize. The chart on the following page illustrates two recent market corrections and demonstrates the differences in drawdown between equity and fixed income indices.
This additional resilience does not have to come with sacrificing income or return. Relative to the equity earnings yield, we believe the fixed income coupon yield is very attractive by historical standards. Valuations of essentially all public asset classes dropped materially in 2022. However, we believe fixed income and credit have repriced to very attractive levels, whereas equities may still have downside risk. One way of thinking about this is to consider the ratio of bond yields to equity earnings yields to assess the relative cheapness of the two asset classes. The relationship is currently at a multi-decade high, favoring bonds over equity. At present, the relationship is 2-3
standard deviations away from the average in favor of bonds.
This is a significant divergence – although it is consistent with other periods in history heading into a recession. Fixed income tends to reprice very quickly when short-term interest rates rise,
whereas it can take longer for equity investments to reprice as investors digest the real economy impact of higher rates over a longer timeframe. We believe that is what has occurred over the last couple of quarters of 2022.
Conclusion
We think 2022 was a pivotal year, marking the shift into a new paradigm – one that will be exemplified by tighter monetary policy, less liquidity, and more volatility. We are still early in this new regime and much is unknown about the future path. We believe investors hoping that heavily equity-focused portfolios will be optimal will be disappointed. We believe investors can benefit from switching a portion of their equity risk to credit risk at the present time to make their portfolio more resilient to market weakness and take advantage of the attractiveness of fixed income yields.
Please feel free to contact us if you would like to discuss this topic further.
Important Information
The information herein is presented by RP Investment Advisors LP (“RPIA”) and is for informational purposes only. It does not provide financial, legal, accounting, tax, investment, or other advice and should not be acted or relied upon in that regard without seeking the appropriate professional advice. The information is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does RPIA assume any responsibility or liability whatsoever. The information provided may be subject to change and RPIA does not undertake any obligation to communicate revisions or updates to the information presented. Unless otherwise stated, the source for all information is RPIA. The information presented does not form the basis of any offer or solicitation for the purchase or sale of securities. Products and services of RPIA are only available in jurisdictions where they may be lawfully offered and to investors who qualify under applicable regulation. RPIA managed strategies and funds carry the risk of financial loss. Performance is not guaranteed and past performance may not be repeated.
The index performance comparisons presented are intended to illustrate the historical performance of the indicated strategies compared with that of the specified market index over the indicated period. The comparison is for illustrative purposes only and does not imply future performance. There are various differences between an index and an investment strategy or fund that could affect the performance and risk characteristics of each. Market indices are not directly investable and index performance does not account for fees, expense and taxes that might be applicable to an investment strategy or fund. “Forward-Looking” statements are based on assumptions made by RPIA regarding its opinion and investment strategies in certain market conditions and are subject to a number of mitigating factors. Economic and market conditions may change, which may materially impact actual future events and as a result RPIA’s views, the success of RPIA’s intended strategies as well as its actual course of conduct.