Milton Ezrati, Partner and Senior Economist and Market Strategist

 

Because the fears forged during the 2008–09 crisis still linger, investors continue to avoid equities. For a while, extreme caution drove almost all new flows of funds into cash and U.S. Treasury bonds. As these flows drove down Treasury and agency yields, investors sought returns in more credit-sensitive bonds, but still, they largely avoided equities. The pattern has by now distorted valuations enough to present a special opportunity in stocks, even after their impressive rise from spring 2009.

 

Mutual funds, though only a piece of the puzzle, capture the general directions of all these funds flows. This year to date, equity funds have seen a net outflow amounting, by some estimates, to more than $300 billion, even as the stock market has made its gains. Bonds, in contrast, both taxable and tax free, have garnered more than $400 billion in net inflows. Foreign investments have gained as well, mostly bonds and most notably emerging market debt.

 

Not surprisingly, relative prices have followed these flows of funds. Investor preferences for fixed-income investments have bid up some bond prices so much that financial professionals have begun to talk of a “bond bubble.” More technically minded observers have argued against such a characterization, but whatever the technicalities, it is nonetheless clear that Treasury and agency prices in particular have risen so far that the 10-year issue now yields less than 3.0%, barely compensating holders for inflation after taking their tax liabilities into consideration. Agency debt is only slightly less unattractive.

 

But not all bonds are equal. Neither corporate nor municipal debt has quite seen the thoroughgoing price pressure that Treasuries and agencies have. To be sure, these more credit-sensitive issues have already enjoyed the bulk of the gains they will likely manage in this cycle. High-grade corporate bonds have almost kept up with government issues. But high-yield corporate bonds still yield some 600–650 basis points (bps) above Treasuries of comparable maturity—still attractively generous compared with the historical average spread of closer to 500–550 bps—while offering a better measure of protection from the capital losses likely in Treasuries and agencies as their yields adjust upward. Similar comparisons stand with municipal bonds and with corporate bonds issued in other developed markets abroad.

 

In these comparisons, emerging market bonds are a special case. Though investors clearly have remained fearful of equities, they have nonetheless shown little fear of the once-risky world of emerging sovereign debt. Their purchases have, in fact, driven up the prices in this area even faster than the prices on U.S. Treasury and agency debt, so that yield spreads over U.S. Treasuries, according to the JPMorgan Emerging Market Bond Index (EMBI+),[1] have collapsed by more than 500 bps so far this year. Emerging market sovereign spreads are still slightly above the all-time, optimistic lows they reached in 2006, but they are well below the averages of the past five or 10 years. Today, for instance, Brazilian bonds offer yields only about 175 bps above U.S.

Treasuries, well below the 700-plus basis-point spreads seen in 2004. Turkish sovereign bonds offer a yield premium of about 160 bps over Treasuries, compared with 350 bps in 2004. Russian bonds offer a spread under 200 bps, compared with closer to 300 bps in 2004.

 

Of course, there is no magic to the 2004 reference. Indeed, circumstances in these markets have changed enough to raise questions about any mechanical comparison to historical spreads. Compared with a decade ago or even five years, these markets show much greater stability, much greater market flexibility, much less inflation risk, and much more prudent monetary and fiscal policies. Credit ratings on these issues have consistently risen, so much so, in fact, that the composition of the popular EMBI+ Index has gone from 20% investment grade 10 years ago to 60% today. The march up over this time has been impressive. Mexican sovereign issues became investment grade in 2002, Russian issues in 2005, and Brazilian issues in 2008. None of these ratings was in jeopardy of downgrading even during the 2008–09 financial crisis. But still, for all these huge differences from the past, the collapsing spreads raise questions about valuations, especially relative to equities.

 

Here, investor neglect has kept prices attractively low relative to earnings and other financial fundamentals, including bond yields. Indicative of trends in most developed markets, the present price of the broad-based S&P 500® Index[2] averages 15 times historical earnings, cheaper than the average of the last 20 years. Equity valuations look even more attractive when compared to bonds. The market’s “earnings yield” (a simple inversion of the price-to-earnings multiple in order to more easily compare stock values to bond yields) today equals 6.5%, almost 400 bps over the current yield on 10-year Treasuries. Since historically the market’s earnings yield has averaged some 200 bps less than the yield on 10- year Treasuries, there is a clear suggestion here that the stock market has considerable upside, could sustain multiples even as Treasury yields rise, and at the very least could keep up with future earnings expansions. Similar calculations overseas show equally compelling valuation differences.

 

Of course, valuation calculations and comparisons are never the whole story on any asset class. Investors also need to account for potential policy shifts, earnings prospects, and volatility, just to name a few other critical issues. But still, these valuation considerations would seem to point to an opportunity to gain from the price distortions that have arisen out of past investor fears.

 

*I would like to thank Vincent McBride, Partner and Portfolio Manager—Lord Abbett International Equity, for suggesting this line of analysis.

 

[1]The Emerging Markets Bond Index Plus (EMBI+) tracks total returns for traded external debt instruments (external meaning foreign currency denominated fixed income) in the emerging markets. The regular EMBI index covers U.S. dollar-denominated Brady bonds, loans and Eurobonds.

[2] The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

 

 

Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

 

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