Curmi & Partners

Valuations marching higher as outlook remains weak

The strong market performance during the first half of 2019 was characterised once again by a high positive correlation bet­ween bonds and equity markets. This theoretically unlikely relationship was again driven by powerful communication by central banks in major economies reassuring the market that they stand ready to increase monetary accommodation in view of a weak economic outlook and subdued inflationary pressures.

The result was a strong rally in government bonds, corporate debt and stock markets. Equity valuations keep marching higher despite the economic and political uncertainty over the short-term and earnings expectations pointing to­wards a depressing reporting season.

The increasing probability of interest rates cuts, which are now considered to be a done deal and which may pave the way to additional measures of monetary stimulus, has triggered a sharp drop in benchmark bond yields and a significant tightening in credit spreads on investment grade and high yield bonds.

Moreover, the growing stock of negative and low yielding bonds continues to fuel the motivation of investors to go up the risk spectrum and add investments with a higher yielding potential in their portfolios.

Therefore, as the outlook points towards slower growth, the underlying mechanism driving up prices is the lower discount, or the additional required return, applied by investors to hold riskier positions – in other words, a general reduction in risk premia.

The strong performance in risk assets shows that maintaining a defensive position and holding high cash balances has been costly even though it was perfectly sensible to adopt such a strategy in the prevailing geopolitical environment.

The key question however is: how sustainable is the rally in bonds and equity markets?

We are potentially now dealing with overcrowded trades and rich valuations reflecting high expectations placed on central banks to deliver on their pro­mises. The dislocation in market valuations versus economic fundamentals seems to have wedged in deeper than before and the risks of disappointment have increased. This state-of-play suggests limited further upside at this point and a higher probability of a market correction that can go some way in restoring balance in risk premia.

A general lack of conviction in the strong market performance is slowly starting to creep in as market participants are starting to warm up to lower earnings growth rates than previously anticipated. In fact, the corporate earnings season may serve as the first catalyst to pinch the market. Much of this will depend not just on the actual results compared to estimates but also on the companies’ guidance on future profitability and their assessment and response to the current trade tensions.

The cost of implementing a defensive strategy too early may still pay off in the short term. However, any market correction will likely provide a good buying opportunity for investors running high cash balances.

The medium term remains uncertain given the highly unpredictable outcome of the trade negotiations and geopolitical tensions. Having said that, the baseline scenario is a prolongation of the current low growth and low inflation environment coupled with highly sensitive and reactive central banks. Low volatility is likely to reign during most time periods with episodes of market corrections offering opportunities to generate commensurate modest returns.

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.