A key question our mentor used to ask is what is your quarrel with price? The S&P500 (the global risk proxy) is trading near the all-time-high despite the risk of a potential oil shock, tariffs, and a potential growth scare (a key reason why the Federal Reserve commenced the easing cycle in September with a super-sized 50 basis point rate cut). To be fair, the equity market has arguably benefitted from the optimal combination of disinflation, resilient growth, and policy easing. Our quarrel is with the current level of risk compensation in markets, rather than a strong view on the business and profit cycle itself.
As we have noted for the past few weeks, the challenge for equities and credit is that even if one believes in a benign outlook for growth and profits, it is already extremely well priced and appreciated. Stated differently, the equity and credit risk premium are extremely narrow relative to history. The difference between the S&P500 earnings yield and the 10-year Treasury yield is non-existent. At the same time, the US high yield credit spread is 200 basis points below the long-term average and near trough levels.
Curiously, US Implied equity volatility has started to rise. That might be a bearish divergence or warning signal for equities. The time series below shows the equity risk premium, high yield credit spread and the VIX as a normalised z-score. The equity and credit premium are more than one standard deviation below the long-term average (chart 1).
Chart 1
It is an obvious point, but human beings cannot see the future. We don’t know if the US economy will experience a genuine growth shock or recession. We also don’t know if the conflict in the Middle East will create an oil shock or if the next US Administration will implement aggressive tariffs and continue with irresponsibly loose fiscal policy. What we do know is that investors are not compensated very well for any of these risks. Although there are similarly upside risks for growth from expansionary policy and a recovery in China, that would imply a higher path of interest rates and a different asset and sector allocation. Our mentor also used to say think symmetrically about risk. Most investors only consider downside or left tail risks.
As we have noted previously, the rise in unemployment from the trough and leading indicators of the labour market (job openings, temporary hires, consumer confidence net-jobs plentiful) is probably consistent with a non-trivial deterioration in cyclical conditions. Macro imbalances and service sector growth momentum is resilient today, however global cyclical conditions are more fragile. Leading indicators of the industrial, inventory and profit cycle appear consistent with weaker macro conditions compared to price itself (chart 2).
Chart 2
In conclusion, the challenge for global equities is that even if you believe in the “soft landing” that is already the prevailing bias among institutional investors. It is also already well reflected in positioning and valuations. We remain positioned light and tight.
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