Curmi & Partners

Too early for the great rotation

By Matthias Busuttil

Financial markets have seen some very dramatic moves since the great financial crisis. The most notable probably remains the stark decline in bond yields. Just last month, we have seen the largest amount of negatively-yielding bonds ever, amounting to over Euro 15 trillion equating to approximately 30% of global debt.

This is the product primarily of substantial central bank intervention in the form of rate cuts and monetary injection programmes, the general preference for safer assets as expected growth rates struggled to gain traction and the decline in inflation.

The fall in bond yields has had the effect of lifting asset prices across all markets. However, capital has flown more generously, or more aggressively, in bond markets as opposed to equity markets.

It is given that equity valuation levels are at very high levels compared to historical standards, to the extent that many consider stock markets to be trading at unrealistically optimistic levels. However, a number of factors suggest that equities remain relatively cheap compared to bonds which became more and more expensive.

The spread on high-yield and investment grade corporate bonds have tightened to historically low levels against benchmark bond yields. A similar development was reflected within sovereign bond markets as well. However, very low-rated CCC bonds, which tend to be correlated with equity market movements, held relatively high spreads during this period resulting in an underperformance versus other bond classes.

Similarly, the differential between the earnings yield on equities and benchmark bond yields has continued to widen over the last few years reflecting the downward pressure on valuations for relatively higher earnings potential.

Secondly, when analysing consensus forecast growth rates of earnings, the current implied equity risk premium have been stable and inching upwards over the last few years. In other words, the additional return required by investors to hold equities has gradually increased.

What this means is that the effect of the so-called “search for yield” was limited in the riskier asset classes – which makes sense when growth is weak and recession risks remain. Does this mean that equity valuations are a fairer reflection of the underlying market risks or is the relative cheapness between equities and bonds explained by the higher protection premium that the safer assets are demanding?

Looking below the surface, within equity markets, the low growth and low inflation environment has supported primarily “pure” growth stocks, such as Tech, as well as quality stocks – companies with strong balance sheets and cash generation. On the other hand, value stocks and cyclical stocks fell out of favour.

Until recently, this has led to the longest period of underperformance in value stocks against growth stocks resulting in the percentage premium in the price-earnings multiple of growth stocks versus value stocks to reach extremely high levels.

Apart from the fast acceleration in earnings reported by Tech companies over the last several years, the rise in growth and quality stock valuations was mainly due to their higher positive sensitivity to falling interest rates (or duration), the lack of growth opportunities as well as greater uncertainty on the economy and the impact of policy.

It is observed that the valuation gaps between cyclical and non-cyclical value stocks, comparing for instance banks versus consumer staples is largely explained by a few variables, namely the economic policy uncertainty, inflation and sales activity indicators.

However, in September we have seen the first signs of reversion in this relationship. The pull-back in benchmark bond yields, following the eventful ECB and Fed policy meetings, accompanied a sharp rotation out of growth and into value stocks. Given the extreme market positioning, even if such a trend proves to be temporary, it can still lead to significant movements in prices.

This rotation seems to display some expectations of a reflationary market environment, where an increase in bond yields is driven by higher inflation expectations, or that the slump in manufacturing activity is finally bottoming out.

Nevertheless, for this rotation within equity markets to be structural, we need to see higher earnings growth expectations with a greater degree of confidence, an uptick in inflation and lower policy uncertainty. Such conditions in the US are becoming more conducive for selected US cyclical stocks to outperform. However, in Europe, as the economic outlook remains challenging, the trend to favour quality or defensive growth stocks is likely to resume while cyclical stocks are likely to remain undervalued due to the greater exposure to downside risk.


The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.