a strategy for the upturn
TRANSCRIPT
αβχ Global Research
Equity markets have benefited the most from improved visibility and are now closer to fair value than credit. This should ensure the latter outperforms in the second half of the year once the recession ends.
After 18 months, there are now convincing signs in the US and the rest of the world that the longest, deepest and most widespread recession since World War II is close to an end. And yet, with all the extraordinary events that have occurred since early 2007, financial markets have performed in a way entirely consistent with every recession since the 1970s.
In fact, with the bubble in credit markets bursting so early in 2007 and the impact this had on the real economy soon afterwards, there were plenty of “early warning signs” to alert for the need to protect against a severe downside in risky assets. For instance, at the end of 2007, investment-grade credit spreads had exceeded the level they had reached prior to the recessions of 1990/1 and 2001, by which point the S&P 500 hadn’t fallen below 1500. If the failure of Bear Stearns in March hadn’t rung enough alarm bells, by the middle of 2008, amid the height of the “decoupling” buzz, US unemployment had risen since the start of the year in a way it had only done so during all previous recessions. At this point the S&P 500 was still above a respectable 1400, down a mere 10% from its record high.
Having peaked two months before the start of the recession, the shortest lead since 1981, the S&P 500 bounced from a hellish low of 666 on March 9th after the US economy had, in Warren Buffet’s words, “fallen off a cliff” and brought the rest of the world down with it. Since then speculation has grown about when the contraction will end. Even the now-ultra-bearish IMF, whose own forecast for no US real GDP growth in 2010 looks pessimistic compared with the “more adverse alternative” assumed by the Fed’s stress tests, said in April that a turnaround should begin this year.
With the debate now moving away from if, to when, the recovery starts, this article looks at how markets have performed during previous upturns and assesses the likelihood of past scenarios being repeated. During past US upturns, the earliest change in relative performance comes three-quarters of the way through a recession when a surge in equities ensures they outperform credit and other risky assets. This lasts an average of six months and finishes anywhere between two and nine months after the recession has ended. Equities then underperform credit for on average, 21 months and anywhere between one and three years. The fact that equities have now recovered as quickly as they have, and in turn outperformed credit by over 19% since March 9th, is more down to the normalisation in market volatility than a sign that equities have turned a decisive corner. Over the next 12 months, credit has become a far more attractive way to take risk compared with equity. From 2010, the performance of equities will depend on how fast bond yields have risen.
Wesley Fogel Investment Strategist +44 7860 264 902 [email protected]
1 June 2009 Asset Allocation Global
Navigator
A strategy for the upturn
Asset Allocation
αβχ
The past two years might become one of the most analysed periods in history, if it hasn’t been already. Countless comparisons with past downturns have been made in an effort to see just how bad it might get. One of the most rigorous analyses came from the IMF, in their World Economic Outlook (October 2008), which looked at 113 financial stress episodes during the past 30 years across 17 countries. Notwithstanding that half of these episodes were not followed by an economic downturn, the study does conclude that the current crisis seems to have had the widest impact.
While a contraction in the world economy is unlike anything seen since World War II, financial markets have so far behaved in a way that is comparable with every US recession since the 1970s. In fact, the most recent episode will be remembered for how well informed investors have been during the downturn. It is easy to forget that expectations for a US recession were almost non-existent up until the start of 2008.
Chart 1 shows that performing a search for the phrase “US recession” in Google News saw its frequency spike massively in January 2008 after the surprise rise in US unemployment to, ahem, 5%. Chart 2 illustrates how stories with “US recovery” started to pick up before the start of the year and significantly so in March, a month after the S&P hit the lowest in over 12 years. Just as financial markets were accurate in timing the start of the recession, they are likely to be as effective in anticipating the start of an upturn.
Chart 1. Equities peaked only two months before expectations for a US recession became widespread
0
1000
2000
3000
4000
5000
6000
Jan-05 Feb-06 Mar-07 Apr-08 May-09650
850
1050
1250
1450
1650
Stories with "US recession" on Google NewsS&P 500 (RHS)
Source: Bloomberg, Google
Chart 2. Equities bottomed as expectations for a US recovery became more commonplace
020406080
100120140160
Jan-08 May-08 Sep-08 Jan-09 May-0965075085095010501150125013501450
Stories with "US recovery" on Google NewsS&P 500 (RHS)
Source: Bloomberg, Google
And given how conventional the performance of financial markets has been in the downturn, it is reasonable to assume that the performance of markets in the upturn will follow a similar pattern to previous economic cycles.
A strategy for the upturn The world economy is likely to recover slowly from late-2009 Equity markets have always rallied towards the end of a recession Credit typically outperforms equity once the recession has ended
αβχ
Of course, any conclusions drawn from history can never entirely relate to the current environment, not least because we don’t know when the current US recession will end. Moreover, it is unclear whether developed markets, in particular the US, will be more or less important in driving future trends in financial markets than in past upturns. However, given that the correlation between risky assets has risen over time, especially so during the most recent episode, we can assume for now that a turning point in the developed world would coincide with little or nor lag to emerging markets.
When to buy, when to sell The performance of financial markets during the end of a recession will be represented by total return series for MSCI developed world equities, Merrill Lynch US investment-grade corporate credit and US 10-year government bonds starting from 1973. Table 1 at the end of this note contains a complete set of results. All recession dates are from the NBER.
There is the potential and arguably a need to extend this analysis to include a broader range of assets, but for the sake of simplicity and given the limited availability of historical data for some markets (in particular within the emerging world) we proceed on this basis for now.
When to buy equities On average, the trough in equity markets has come ten months from the start or, on a comparable basis, over three-quarters of the way through a recession. Chart 3 shows how the earliest of any trough has been four months from the start of both of the 1980 and 1990 recessions, each of which lasted six and eight months respectively. Despite there being less than a year between the double-dip recessions of 1980 and 1981, equities recovered by almost 30% from their low during the period.
Chart 3. Equities trough during the second half of a recession and have returned an average 20% after one year
0
5
10
15
20
1973 1980 1981 1990 2001
0%10%
20%30%
40%50%
Trough in equity prices (months before/after recession)Trough in equity PE ratio (months before/after recession)12-month return from trough, %Duration of recession (months)
75
Source: Bloomberg, Author’s calculations
On average, equities have risen by 20% one year from their recessionary low. This was as high as 45% following the recession in 1981, while the only decline came following 2001 (-22%) when the recession ended in November, two months after the 9/11 attacks.
Chart 4. Equities briefly outperform corporate credit three-quarters of the way through a recession
0.30.40.50.60.70.80.91.01.11.2
Mar-73 Mar-82 Mar-91 Mar-00 Mar-09
US recessions Equity relative to credit
Source: Bloomberg, NBER
Chart 4 shows the earliest change in relative performance during a recession, which is between equity and credit. Relative to credit, equities start to outperform three-quarters of the way through each recession. This outperformance has lasted on average six months and has ended anywhere between two and nine months after the recession has finished. Once this outperformance ends, equities have then underperformed corporate credit by on average 21 months, anywhere between one and three years.
αβχ
When to sell government bonds In every previous recessionary period, there has been ample opportunity to benefit from holding Treasuries even after a recession has ended. Except for the time between the double-dip recession of 1980/81, government bond yields have continued to decline for up to two-and-a-half years and on average two years after each recession ended.
Chart 5. US 10-year bond yields have bounced from a historical low
24
68
1012
1416
Jan-60 Jan-72 Jan-84 Jan-96 Jan-08US recessionsUS 10-year government bond yield, %
Source: Federal Reserve. NBER
Chart 6 shows how once yields finally reach a trough, government bonds have delivered an average return of -6.3% in the following year. These returns were as low as -12% following the trough in 1980 (immediately following which came the recession in 1981) and as high as 0.4% after the 1973 recession.
Chart 6. Government bond yields have risen at various different stages of each recession
0
10
20
30
40
50
1973 1980 1981 1990 2001
-15%
-10%
-5%
0%
5%
US Gov t y ield trough (months before/after start of recession)12-month return from trough in y ields, %Duration of recession (months)
Source: Bloomberg, NBER, Author’s calculations
Chart 7. US inflation has always fallen from the middle of a recession
-113579
111315
Jan-70 Jan-76 Jan-82 Jan-88 Jan-94 Jan-00 Jan-06US recessions US headline inflation, Y/Y
%
Source: Bloomberg, NBER
As Chart 7 illustrates, inflation has always fallen during a recession and continues to fall over the following months. An exception to this was the period following the 2001 recession, although arguably it was the risk of deflation and consequent further loosening of monetary policy which ensured that inflation would pick up in the following months.
When to buy corporate credit The point at which it has become attractive to own credit during a recession has been very consistent over time.
Chart 8. Credit spreads peak an average of ten months after the start of a recession
0
5
10
15
20
1973 1980 1981 1990 2001
-10-505101520
IG credit peak (months before/after start of recession)IG credit 12-month returns after spread peak, % (rhs)Duration of recession (months)
Source: Moody's, Bloomberg, NBER, Author’s calculations
Credit spreads peak an average of ten months after the start, or close to the end, of each recession. The deleterious effect of higher credit spreads on corporate earnings and the consequent pick-up in default rates has meant that the best time to buy credit is once the recession has ended. On average, returns
αβχ
one year after the peak in credit spreads have been 9%, with the only negative return in 1980 (-6%), while it was above 15% during the recessions of 1973 and 1990.
An unconventional upturn The performance of safe and risky assets since 2007 seems to have conformed surprisingly well to the end of previous US recessionary periods. This is somewhat surprising given the unprecedented (and global) nature of the current crisis. In response to such events, unconventional steps have been taken by policymakers around the world; it will arguably be the second-round effects of these policies that will determine how the performance across asset classes differs to previous upturns.
Chart 9. Credit markets are thawing with the TED spread now the lowest since August 2007
0.00.51.01.52.02.53.03.5
Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08US recessionsUS 3-mnth Libor - US 3-mnth T-bill ("Ted Spread")
%
Source: Bloomberg, NBER
Efforts by the Fed to normalise interest rate spreads, by increasing the flow of credit, has had a dramatic effect in bringing down the cost of borrowing between banks. The TED spread, the difference between what banks and the US Treasury pay to borrow for three months, is now below the level it was before the failure of Lehman Brothers in September.
Less than two weeks after the Fed announced the Term Asset-Backed Securities Loan Facility (TALF) on November 25th, investment-grade credit spreads peaked at close to 600bp. Since then, spreads have fallen by over 200bp to around 400bp. This rapid narrowing in spreads has been all the more
encouraging given that it has come during a global recession and the continued worsening of market sentiment. This headwind became apparent during February and March when spreads widened again but stopped short of renewing their highs. Even with large-scale purchases by the Fed providing a much-needed financial stimulus, the FOMC’s recent minutes acknowledge that corporate bond spreads remain extremely high by historical standards. As Chart 10 shows, the spread on Moody’s Baa corporate debt is still double the 50-year average.
Chart 10. Credit spreads are still twice the long-term average
0
100
200
300
400
500
600
Jan-60 Jan-72 Jan-84 Jan-96 Jan-08US recessionsBaa bp spreadLong-run average
Source: Moody's, NBER
Credit where it’s due While a trough in equities has usually come before a peak in credit spreads, during this recession spreads peaked three months before equities bottomed. Since that peak, credit has returned over 11%.
Chart 11. Since spreads peaked in December, returns from credit have been over 11%...
200
300
400
500
600
700Jan-08 Jun-08 Nov-08 Apr-09
84
88
92
96
100
IG credit spread, bp (inverted)IG credit total returns (rhs)
Source: Merrill Lynch
αβχ
While this is the highest annualised rate of return of all of the previous recessions, it is not much greater than the 18.5%, 12-month return that credit delivered after the peak in spreads during the 1970s recession. Given that spreads remain historically high, there is considerable potential for credit to perform strongly once there are convincing signs that the recession has ended. As Chart 8 shows, apart from the negative return after 1980, whenever spreads have peaked before a recession has ended, 12-month returns have been above 15%.
Once the upturn does begin, the focus will quickly turn to the inflationary impact of quantitative easing. In the FOMC’s recent minutes, there was some discussion surrounding concerns that “the expansion of the Federal Reserve’s balance sheet might not be reversed in a sufficiently timely manner and hence that inflation could rise above rates consistent with price stability.” This concern is still in its infancy, as 10-year breakeven rates remain contained, still below the 10-year average of 2%.
Chart 12. … despite an increase in equivalent-maturity risk-free rates since the start of the year
1
1.5
2
2.5
3
3.5
4
Jan-08 Jun-08 Nov-08 Apr-0984
88
92
96
100
5-year bond yield, % IG credit total returns (rhs)
Source: Merrill Lynch
Chart 12 shows the recent upward trend in the yield of government bonds with comparable maturity to the Merrill Lynch US Corporate Master. In 2008, a rapid sell-off in Treasuries contributed towards the negative returns from credit at a time when spreads were actually narrowing. This time around, with spreads falling more rapidly and Fed purchases keeping Treasury yields lower than they otherwise would be, the environment for credit is far more favourable.
With the increasing likelihood of a disappointingly sluggish economic recovery together with considerable uncertainty surrounding the timing of any reversal of monetary easing, this should provide a sustained support for credit in coming quarters.
Still going cheap This argument is further supported by comparing the relative value of credit to equity. One way to do this is to compare the equity-risk premium and the corporate-risk premium over time to see how cheap credit spreads are compared with the equity premium. This doesn’t tell you about the absolute cheapness of the two markets compared with government bonds, only their relative cheapness. That they are not exactly the same thing shouldn’t matter as they both measure similar things.
Chart 13. Credit risk premia still one standard deviation cheap against equities
0.51
1.52
2.53
3.54
4.55
5.5
Jan-86 Jul-93 Jan-01 Jul-08
ERP/IG spread -1 Std. dev+1 Std. dev Average
Source: Bloomberg, HSBC, Author’s calculations
Chart 13 shows extreme valuations of one market against the other; i.e. those of one standard deviation or more. This shows the US equity-risk premium divided by the US investment-grade corporate spread back to 1986, since this is as far back as the data goes. The red line is the average over the period and the black lines measure one standard deviation around that average. The bottom line shows when credit is one standard deviation cheap and the top line when equities are one standard deviation cheap.
The chart picks up the extreme expensiveness of valuation of equities versus credit in the late 1980s, before the 1987 crash; the extreme cheapness of
αβχ
equities compared with credit in the mid-1990s, in particular in 1994 and 1996; and the extreme expensiveness of equities compared with credit in the late 1990s and early this decade. As a result of its dramatic moves since early 2007, credit has remained at an extreme under-valuation compared with equities. Though not as extreme as in the stock market bubble, the interesting thing is this has happened even though stock prices had been falling for almost 18 months. Risk premia on credit have simply been rising faster than risk premia on equities.
Chart 14. IG excess returns over equities one year from occasion from when one standard deviation cheap
- 40%
- 30%
- 20%
- 10%
0%
10%
20%
30%
40%
50%
Jun-82 Jun-87 Jun-92 Jun-97 Jun-02 Jun-07
IG credit excess 1-yr return relative to equity
Average 15.6%
Source: Bloomberg, Author’s calculations
Chart 14 shows the excess returns from investment-grade bonds over equities one year from all the months they were one standard deviation cheap compared with equities. Investment-grade credit has delivered excess returns one year later of 15.6% on average.1 Since credit first became extremely undervalued compared with equities in January 2008, the average 1-year excess return for the following four months was 31%.
A (more) normal equity market Given that equities had fallen further and faster than in any previous recession, the fact that in the past three months they have delivered all and more of the
1 A year from when they were expensive against equities,
investment-grade credit delivered excess returns over equities of,
on average, minus 12%.
average 12-month return from their trough during previous downturns (excluding 2001) was in many ways to be expected. Equities have recovered as quickly as they have, and in turn outperformed credit by over 19% since March 9th, more as the result of the normalisation of market volatility than as a sign of equities turning a decisive corner.
Chart 15. After a dramatic fall in the Vix, underperformance of credit relative to equity has now started to reverse
25
3035
4045
5055
60
Jan-09 Feb-09 Mar-09 Apr-09 May-0995
100105
110115
120125
130
Vix Credit relative to equity (RHS)
Source: Bloomberg
Chart 15 shows that once the Vix had remained below 50, equity started to outperform credit. With the steady decline in implied volatility a key factor behind the recent surge in equities, there is limited potential for this to be sustained once market conditions have stabilised. In addition, as Chart 16 shows, equities are now close to their long-run fair value with limited upside potential given the still-uncertain global economic outlook.
Chart 16. Equities are now around fair value
05
1015202530354045
Jan-60 Jan-72 Jan-84 Jan-96 Jan-08US recessionsS&P 500 PE ratioLong-run average
Source: Robert Schiller
Wesley Fogel
αβχ
Appendix Cross-asset performance
Table 1. US recessions and peak/trough asset class performance
Peak/Trough, months before/after start of recession
1973 1980 1981 1990 2001 Average 2007
Date of recession November 1973– March 1975
January 1980– July 1980
July 1981 – November 1982
July 1990 – March 1991
March 2001 – November 2001
Duration of recession
16 6 16 8 8 11 18?
Peak in equities -10 3 2 -6 -13 -5 -2 Peak in government bond yields
23 2 2 -3 -14 2 -6
Trough in credit spreads
5 -16 1 -4 2 -2 -8
Trough in equities
12 4 14 4 16 10 15
Trough in government bond yields
38 6 22 39 27 26 12
Peak in credit spreads
15 5 16 5 8 10 12
Returns, % 1973 1980 1981 1990 2001 Average 2007 Equity peak to trough fall
-45.1% -9.1% -15.3% -28.5% -48.0% -29.2% -56.0%
Government bond return from peak to trough in yields
24.1% 23.7% 72.4% 67.1% 51.5% 47.7% 24.6%
Corporate credit return from trough to peak in spreads
-2.5% 0.5% 39.3% 6.3% 8.1% 10.3% -8.9%
Equity 12-month return from trough
26.4% 26.5% 44.7% 23.1% -22.1% 19.7% 34.5% (since March 9 2009)
Government bond 12-month return from trough in yields
0.4% -11.6% -5.2% -9.3% -5.6% -6.3% -5.0% (since Dec 30 2008)
Corporate credit 12-month return from peak in spreads
18.5% -6.1% 11.9% 16.4% 3.9% 8.9% 11.0% (since Dec 8 2008)
Source: Bloomberg, Moody's, Author’s calculations
