Randy Masel, Managing Director (January 19, 2016)
Are We There Yet?
Given how the markets have traded so far in 2016 I guess I should be glad that I have procrastinated so long in writing this commentary and outlook. The 8% drop in the S&P 500 index in the first two weeks of the year has had to shake the conviction of even the most bullish of prognosticators. And the daily parade of bearish news stories and some panicky analyst reports (RBS’s call to “sell everything”, e.g.) has made many investors wonder if anyone has any idea how 2016 will turn out. The ride for investors may stay bumpy for a while. I think the key question, given the dramatic drop in prices for so many risk assets, is: “What is priced in already?” To get a better understanding of where we might be headed, a quick review of where we have been may be in order.
The Rear View Mirror
For the record, the total return on the S&P 500 was 1.37% after dividends in 2015. High yield fared worse. The Bank of America High Yield II Master Index returned -4.64%. The yield-to-worst call on the index ended the year 2.11% wider at 8.76%. Risk premiums, in the form of a spread over Treasuries, widened 1.85% to just under 7%. High yield investors can take solace that they did not put their money in a barrel of West Texas Intermediate crude oil, which dropped 39% in price over the course of the year. Carnage was evident in many other areas as well: emerging markets, metals, MLPs, etc. all posted double-digit declines. The dramatic drop in the price of many risk assets came against a backdrop of moderate but slowing economic growth both domestically and internationally. Oil, metals, and China, all inextricably linked, conspired to scare investors.
What is Priced In?
It is easy to feel anxious listening to or reading the financial media that speaks of “routs” and “beatings” and the worst financial start to a calendar year since beads were traded for flints. But because a stock or bond is down in price today does not mean that it will be down tomorrow. It just means that it is closer to its bottom. In the high yield market in particular, a lot of pain has already been inflicted and a good deal of bad news is priced in. Yes, defaults will increase in 2016 unless energy prices start recovering in a hurry. However, the average high yield energy bond is already trading at 59% of par and the average CCC natural resources bond is trading in the 40’s. Recoveries on high yield defaults have averaged 40 cents or so on the dollar, so clearly an awful lot of bankruptcies are already priced into the market. It is certainly the case that recoveries for energy companies that have resorted to second lien financings could be much lower if prices stay down here. But the default cycle is likely to be the precursor to some recovery in energy prices and the recovery rate upon bankruptcy exit, which could take a year or two for most companies, may end up being somewhat higher than what current pricing would indicate.
Of course, if the economy continues to weaken and capital markets access tightens further, companies outside of the energy patch will start defaulting in greater numbers. Economists surveyed recently by The Wall Street Journal forecast a 17% chance that the U.S. economy will enter a recession in 2016. But again, a lot of bad news is already priced into the high yield market. The current high yield premium to Treasuries to the worst call date is 7.90%. I went back to see what that figure was over the last two recessions (March 2001 to November 2001 and December 2007 to June 2009). Because one does not know exactly when the recession will occur and defaults often lag a recession, I added a year on to each end of the recession to come up with a stress period. The average spread in these stress periods was 7.76% in the 2001 recession and 7.94% in the Great Recession of 2007-2009, on par with the 7.9% current level today. Spreads did peak at much wider levels in each recession so certainly there could be more pain to come but, given that the average spread over the last thirty years is 5.78%, I think it is fair to say that a lot of bad news is priced in at current levels.
Equity valuations might not have quite as much bad news priced in as high yield does today, but the current reset in prices puts stocks at much more attractive levels. The P/E ratio on estimated 2015 S&P earnings is down to 16.8x from over 18.25x at year-end and near its 60-year average of 16x. A full-blown recession does not appear to be priced into stocks, but as mentioned earlier, this is an unlikely (but not improbable event). A profit recession (where earnings go down) does appear priced in, however. According to data compiled by Deutsche Bank, prior to last year, there have been six years in the last sixty where S&P earnings dropped in a non-recession year. Earnings dropped on average 4.1%, and the largest drop was 10.5%. However, in each year P/E multiples expanded in anticipation of stronger earnings the following year and the S&P ended up on the year.
There is an awful lot of fog on my 2016 windshield right now. I am not at all of the belief that we are entering a period similar to the Great Recession of 2007-2009, where contagion across certain financial assets precipitated an existential crisis in the banking system. The regulatory regime put in place post crisis has resulted in well –capitalized banks with lower risk profiles. The drop in oil and other commodities prices does not have the same contagion characteristics in any event. Moreover, it is hard to make the argument that lower input costs derived from oil and commodities will not benefit large chunks of the economy over the longer term. I also do not think the market downturns in 2000-2002 are a good precedent either. Valuations are much more reasonable currently. The P/E at 1999 year-end was 28.8x and the S&P had run up 352% over the course of the nine preceding years. In the sixteen years since the end of 1999, the market is up just 40%.
I am not suggesting that all is rosy. Economic growth around the globe is anemic. And while we happen to live in the U.S., which is the best house in the neighborhood, we are not immune to what happens elsewhere. That being said, I do think high yield prices paint a picture that is too dire. We ended 2015 with a yield-to-worst call of 8.76% and in just ten trading days that has widened to 9.42%. The average high yield bond is currently trading at 86 cents on the dollar and would have to drop to around 80 cents before investors would start losing money from here, given an average coupon of 6.7%. I expect high yield returns to approximate the coupon in total return in 2015. A bounce in energy prices could result in double-digit returns. As I wrote last month, high yield posted a negative return last year but over the last thirty years the high yield market has never been down two years in a row. Big coupons can overcome a lot of ills.
It is harder to be quite as definitive about equities as they behaved much better than high yield in 2015. As previously noted, valuations are pretty much in line with historical averages. Estimates for 2016 real GDP growth are around 2.4%, add another 1.5% or so for inflation and another 2.2% for dividends, and you have a basic recipe for a 6% total return. This simplistic analysis assumes many things, including a stable earnings multiple and the ability of global companies to withstand a strong dollar and the impact of weakening economies outside the U.S. It is, however, a useful way to think about potential returns this year.
One thing that I have written about previously and is worth reiterating is how dividends continue to support equity valuations. Since interest rates plummeted in 2008, the S&P has occasionally yielded more than the ten-year Treasury. Prior to 2008, such occurrences were rare, with the last time being in 1962. One could argue this simply means that Treasuries yields are too low. However, I think the combination of low commodity prices, a strong dollar, and moderate economic growth will continue to temper inflation. Although the Federal Reserve may hike its target Fed Funds rate a couple of times, the impact on the longer end of the Treasury curve is likely to be muted. Dividends are not the main reason to own equities but can be a key component in total return. In fact, in 2015 dividends were responsible for all of the return of the S&P index.
Randy Masel manages a high yield corporate bond strategy that he created and launched upon joining Granite Springs Asset Management in January 2014. He also manages Granite Springs’ Tactical Equity strategy.
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