As a rule of thumb, equity people are optimists and bond people are more sober. Equities is about upside; bonds are about avoiding defaults. So it is strange when equity fund managers sound cautious about their asset class, and when bond fund managers seem relaxed – especially given the conventional wisdom that rising interest rates are bad news for bonds.
But that is what interviews by AsianInvestor with portfolio managers in the United States has found.
This is not because bonds are seen as better value than equities: its that all asset classes seem expensive now, making it hard to know how to best allocate the next dollar.
“It’s tough to find areas to get excited about,” said Boston-based Hayes Miller, head of multi-asset for North America at Baring Asset Management. Noting market average price-to-earning ratios for US equities have reached 19x, Hayes said the last time the S&P 500 Index was this expensive was in 1995, as the tech bubble was heating up. But at least that reflected companies’ optimism, spending and hiring. Today companies are hoarding cash or engaged in share buybacks and M&A. “This time they’re living on central bank life support,” he said.
Most managers argue equities are not (yet) overvalued, but no one says they are cheap. “Equities are not wildly expensive but they are rich,” said Jeffrey Knight, global head of investment solutions at Columbia Management in Boston. “I would not forecast a multiples expansion.”
Martin Flood, portfolio manager at Lazard Asset Management in New York, said zero interest rates initially pushed investors into safe equities offering yield, such as utility stocks. They have become expensive, so his portfolio is underweighting them. Capital then moved into consumer staples, which have also become expensive – followed by capital-intensive companies such as railroads.
“We need to look at the margin structure of companies,” he said. “What’s next?” Given overall sluggish GDP growth in the US and average P/E ratios passing their pre-crisis 2007 peak, it’s difficult to see how many companies will achieve the earnings implied in their stock price. “So we look for stocks that are defensive, or cash-rich,” he said.
Buy backs are a short-term boost to investors. More broadly, Flood said world-class companies with solid balance sheets and streamlined businesses are likely to provide a haven.
Robert Manning, CEO at Boston-based MFS Investment Management, agrees that high-quality multinationals are a good bet right now.
“Those stocks could take a hit too [in the wake of financial market volatility] but not as badly and not for as long [as the rest of the market],” he said. Manning argues equities in the US remain fairly priced based on historical comparisons and are cheap compared to bonds. “I believe the equity market is right and the bond market is wrong” in terms of value, he said.
Manning is among the more bullish when it comes to stocks, predicting US stocks’ multiples will enter the 20s. “There’s going to be a big run-up and the market will see another 20% to 25% rise,” he said, explaining stocks are “the last place for investors to go”, as rising interest rates put a crimp on carry trades in fixed income.
Eric Sorensen, president and CEO at PanAgora Asset Management in Boston, agrees that equities are fairly priced today, and will ride out any short-term bumps as the Federal Reserve changes course.
“I don’t think things are terribly extended,” he said, notably in Europe and Japan, where equity market valuations are cheap compared to the US. He recommends investors maintain exposure to high-quality companies across a variety of sectors.
But other portfolio managers are more cautious. Columbia’s Knight argues diversification won’t help because correlations are too high. Investors should not be overweight risk, but maintain a neutral weighting to equities and reduce position sizes.
Perhaps the most careful note was sounded by Colin Morris, portfolio manager at First Eagle Investment Management in New York. Although corporate earnings are robust, five years ago these stocks represented real value opportunities. “Today the US stock market is fully valued based on what we know,” he said. “What I fear is what we don’t know.”
He argued that the social costs to transferring private debt to public balance sheets and shifting capital allocation from investment to share buybacks has led to social unrest in the developed world. He wonders where economic growth will come from next, or where companies that generated earnings by cutting costs will find new ways to make money.
Morris is also concerned about geopolitical risks that markets are not able to price. “The wolves are at the door,” he said. “If you’re not nervous, then you’re not listening.”
For equity fund managers, he said the mission today is to create portfolios that can survive any environment. “Is my capital safe?” is the important question today, he said.
That sentiment is echoed by the other fund managers, perhaps not as plainly, but in the sense of protecting equity exposures, seeking quality or defensive positions, scaling back risk, being wary of volatility, and pursing absolute return-like strategies rather than following a capital-weighted index.
In short, equity fund managers and multi-asset specialists in the US are structuring portfolios to survive a surprise shock, not to generate double-digit returns. They sound like fixed-income investors.