Equities have seen intense selling pressure in the last few days, moving lockstep with the broad de-risking seen in bonds, commodities and currencies and is the most intense since the Fall 2012, following the 2012 elections. As much as it may sound like “stepping in front of a freight train.” Thomas J Lee, CFA of JPMorgan believes we are at the front-end of a regime shift toward eventual rising rates away from a declining/flat rate environment—a regime that will favor equities in coming years. He says there is already ample evidence seen in risky markets performance in 2Q (and 2013).
Equities up and Bonds Down–the 2nd Time in Past Forty Years details below
#1. For the second consecutive quarter, equities are up and bonds are down–the only other time in the past 40 years was in 1998. The fact that stocks rose in 1q and 2q while bonds fell in both periods (we are using JPM Aggregates, JGAGUSUS index) is rare and only happened previously from 4Q98-1Q99 (see Figure 6), in the subsequent quarter, stocks rose 6.7%. In other words, the divergence of equities and bonds directionally is not a bearish sign.
#2. Equity/HY relationship is de-coupling: Equity P/E expands while HY P/E down 4x. In 2Q13, equity P/E re-rated higher (14.7x currently) while HY P/E is de-rated (from 19.7x to 15.7x currently) see (Figure 7). This de-coupling has not taken place since 2009 and in our view, is a move toward normalization of relative value. Since 1980, equities have traded at a 4x premium to the HY P/E (inverse of HY YTW, CSSWHYI index). This implies that the convergence of multiples (to long-term averages) implies a 5X re-rating of equities to HY. That is, if HY YTW stabilizes here, equity P/E should be high-teens.
#3. Cyclicals beat Defensives in 2Q for the first time in 4 years and are a better forward hedge against rising rates. Cyclicals are on track to outperform Defensives in 2Q by 300bp. This has not happened since 2009. In our view, the risk/reward for Defensives is challenging in a world of rising rates—after all, rising rates ultimately imply investors will want higher dividend yields (hence, a lower price for the equity). We see better risk/reward for Technology into YE and we like Healthcare given its lower P/E multiple. But as we have written about several times, during past rising rate regimes, Cyclicals were the best defense against rising rates—a la 93/94.
What could go wrong? The key risk, in our view, is if the Fed loses credibility. That is, long-term rates and corporate bond spreads move in a direction away from intended policy. This is not an issue at the moment. In fact, the Fed’s current stance provides a good risk/reward for equities. If the economy strengthens, the Fed would reduce its asset purchases, but the key is stronger growth (which helps equities). And if the data weakens, and the Fed extends its window, this helps equities as well.
#1: US Equities outperforming QTD…
As shown on Figure 3 below, US equities QTD returns of 3.8% and YTD returns of 13.8% are among the best performing of risky assets in 2013. What is notable is the relative outperformance of equities compared to credit (high-grade and high-yield), as returns on credit and equities had been highly correlated since 2009.
- As shown on Figure 3, the only assets posting positive returns in 2Q were equities (US, Europe, and Japan). Gold is the worst performing asset class—down 18% ytd and nearly 11% in 2Q
#2: Bonds/Equities de-couple: Bonds down, stocks up…
One of the notable developments in 2Q is the de-coupling of the returns between bonds (corporate and to an extent Treasuries) and equities. We compare the quarterly return of corporate bonds (as measured by the JPMorgan Aggregate Bonds index, JGAGUSUS Index) and S&P 500 on Figure 4 below.
- For the second consecutive quarter, equities have risen while bonds have fallen. As shown on Figure 4 below, this is the second time since 2009 this happened. The other instance was 4Q10.
- The driver behind 2013’s outperformance of equities has multiple factors: (i) bond yields have fallen to levels that make further spread compression challenging (given returns offered); (ii) credit and fixed income markets have become sensitive to the notion of regime shift to rising rates; (iii) equities have re-rated given their P/E discount to current yields on bonds (HG and HY).
- Stocks up and Bonds down in a quarter bodes well for 3Q13. Since 1987, whenever equities and bonds de-couple (like 2Q), tends to bode well for equities. As shown on Figure 5, there are 16 instances since 1988 when bonds were down and equities were up. As shown, stocks, equities produced an average gain of 3% in the subsequent quarter.
More to the point, two consecutive quarters of de-coupling has only happened one othertime since 1988…. positive for stocks
But perhaps what is the most striking is the fact that this is the second consecutive quarter of equities rising while bonds fell. This has only happened one other time since 1988.
- The only other instance of this taking place two consecutive quarters is 4Q98 and 1Q99. In the following quarter, equities went on to gain another 6.7%.
- We believe this is really highlighting a key regime shift. Equity returns and bond returns are set to de-couple. The drivers are interest rate sensitivity and the relative value differential (P/E vs yield) of equities.
- In other words, we believe this shift is reinforcing the favorable bias for equities.