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Central and Eastern Europe Poised for Comeback

Interest rates are at record lows in the euro area, as a result of which investors can feel a great deal of pressure to achieve acceptable yields. This situation shifts their focus back to the countries of Central and Eastern Europe (CEE). “Central and Eastern Europe currently comes with more positive aspects than one might think. There are factors at play that might drive investor attention to this region in the foreseeable future,” says Robert Senz, head of fixed income fund management at Erste Asset Management. The risks are largely of a political nature, as the tensions with Western Europe with respect to migration, the possible Brexit, the Ukraine conflict, and the re-emergence of nationalistic economic policies suggest.

“In the coming years, the gross domestic product in the region is going to experience strong growth at rates significantly above the growth perspectives of the core EU states.” For 2016 analysts expect GDP growth of +3% and above for countries such as Poland, Romania, and Turkey. Hungary and the Czech Republic will be growing at more than +2% this year and in 2017 (source: Bloomberg consensus estimates). Even Greece, after years of crisis, is starting to recover and might show a significant sign of life at +1.6% next year.

On the bond markets investors can expect a yield of 3.5 to 4.5% against a stable political backdrop. With its purchase programme, the ECB contributes to a run on euro government bonds and corporate bonds. But as far as ESPA BOND DANUBIA is concerned, the central bank can only buy 4% of the bond universe. The risk is therefore manageable and is largely restricted to the geopolitical level. The low exchange rates of the local currencies support exports. “The increase in purchase power acts as driving force for domestic consumption”, explains Anton Hauser, senior fund manager of the East European fixed income flagship fund ESPA BOND DANUBIA. The level of debt of the East European countries and companies also support the case for the investment region. In contrast to earlier crises, for example in 1998 and 2008, the debt ratios are now not excessive. Current account and budget deficits in the region are low. Competitiveness is up. In the most recent location ranking by the World Bank, 10 out of 20 East European countries had improved, among them Poland, Russia, and Slovenia.

After the CEE equity markets lost more than 40% of their value post-Lehman in the past five years (in euro terms), a trend reversal has recently become more probable. The stock exchanges benefit from the recovery of the commodity prices, especially the oil price, which has almost doubled since its February low.

Russia: potential in spite of oil and sanctions
Russia was most affected by the falling commodity prices, which came on top of the sanctions imposed by the EU and the USA. The GDP of the, surface-area-wise, largest country decreased by 3.7% last year. Even if the Russian economy will not be able to grow yet in 2016, the first indicators have started suggesting a recovery: inflation has fallen from its high of 16.9% (2015) to most recently 7.3%. We expect the central bank in Moscow, which reduced its key-lending rates only last week to 10.5%, to continue cutting rates in the coming months and thus to support economic growth.

Stock exchanges benefit from the comeback of the convergence story
The stock exchanges in the area command comparatively attractive valuations. At a price/earnings ratio of 11.3x, the CEE equity markets offer a valuation discount of 25% vis-à-vis the stock exchanges of core Europe. “And although the estimated earnings growth in Eastern Europe is still not convincing, the potential is intact for equity investors”, explains Peter Szopo, head of equity fund management of Erste Asset Management in Vienna. While the indices are dominated by the energy and banking sectors, it is the strong influence of commodities that may have positive repercussions on the market if the commodity markets were to stabilise further and gradually recover. Some of the biggest and most profitable energy and commodity producers in the world are based in Russia. They have benefited a great deal from the depreciation of the country’s currency, i.e. the rouble.

Turkey: young population, young economy
At a joint total of 74%, Russia and Turkey command the biggest weighting in the East European equity fund ESPA STOCK EUROPE-EMERGING. The Turkish equity market offers access to a rapidly growing, young economy with one of the best demographic developments in the world. The P/E is currently a low 7x.

Dividend yield clearly above European stock exchanges
The relative attractiveness of the East European stock exchanges is also reflected in the dividend yield. East European companies are currently traded at an average dividend yield of more than 4% p.a., i.e. clearly higher than the yields in Europe (3.8%) or on the global emerging markets (2.8%).

Political risks remain in place
The stock exchanges in Eastern Europe have not managed to de-couple from the global markets. There are still risks with regard to global growth, the interest rate policy from here on in (especially as far as the rate hikes in the USA are concerned), and the development of the local currencies. Investors will be monitoring the political development in Russia and Ukraine closely. At the end of the year, Russia will be holding parliamentary elections. Turkey and its constitutional amendments will draw a lot of attention. Lastly, there is Greece, where the debt crisis has not been fully overcome and no agreement with the IMF and the EU has been ratified yet. While the possible, albeit not likely, exit of the UK from the Eurozone (Brexit) would not have the same kind of significant effects on the CEE countries that it would have on Ireland, the Netherlands, and Germany, one would have to brace oneself for price spikes and volatility as well as for widening spreads in line with other financial centres, as Szopo points out.

XP Investimentos is Looking to Replicate their Business Model with XP Securities in the United States

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As in the previous six years, XP Investimentos will hold its annual event for Latin American professionals working in the investment, asset management, and insurance industry. This year, the Expert event will be attended once again by Bernardo Amaral, Chief Executive Officer at XP Securities, the US subsidiary of the firm, which is the largest independent broker-dealer in Brazil, with more than 600 hundred employees and more than BRL 40 billion in assets under management.

Amaral joined XP Investimentos in Brazil, in 2007, as Legal and Compliance Manager. After seven years in the firm, he changed his residence to the United States, where he took charge of the business, becoming the Chief Executive Officer of XP Securities. In an interview with Funds Society, Bernardo Amaral talks about the contributions of the Brazilian firm to the US market, their growth strategies in the institutional business, asset management, and wealth management for HNWI and the company’s expansion plans in Latin America. Hereunder, his answers:

XP Investimentos developed a new concept of investment firm in Brazil, what can XP Securities bring to the US investment market?

XP Investimentos has a very strong company-wide business model that has proven to be extremely successful in Brazil. We are looking to replicate this business model with XP Securities in the United States. XP Investimentos brought to Brazil the concept of the one-stop-shop financial institution, where products are offered through a network of independent investment advisors. Until 5 years ago this concept was practically unheard of in Brazil. Through combining quality products and unbiased distribution, we have been able to attain impressive numbers. We can confidently say that we know what advisors need in order to be successful. The fact that XP Investimentos has 70% of all independent financial advisors in Brazil is proof that XP offers the tools and structure necessary to allow independent advisors to be successful. We are looking to bring these same concepts to the US. Despite the fact that US financial markets are mature in this aspect, we feel that there is room for new approaches and development. In the US there are still extensive opportunities in terms of our usage of available technology so that advisors can scale service. In Brazil, for example, XP created an intelligent CRM system that combines efficiency and intelligence, which allows advisors to service a large number of clients. On the operational side, another significant innovation was the creation of a tool in Brazil that allows XP to send messages directly to clients’ cellular phones, which is used to provide clients with investment opportunities and, with a simple response via text message, clients can take advantage of the opportunity being offered. We are evaluating the possibility of replicating these practices here. This is the challenge.

The first XP Securities office was opened in New York back in 2012, two years later the Miami office was opened, is there any difference in terms of business focus between the two offices? How big are the teams in each office?

We have approximately 25 people in each office for a total of 50. We just moved our NY office to a large space and we are doing the same in Miami. The main focus of the Miami office is the servicing of retail clients (mainly high net worth). On the other hand, the New York office services institutional clients, which includes both US clients trading in Brazil or throughout other parts of Latin America, or Latin American clients trading in the US or any other part of the world.

XP Securities has a focus on institutional investors in the US willing to enter Latin American markets, what capabilities are offered to this type of investor?

In relation to Brazil, we are able to bring American investors a flavor of what is going on in local markets through XP Investimentos and its team of economists and political analysts, as well as through corporate access (which allows us to connect non-listed companies and experts to international investors). Furthermore, we have excellent capacity for trade execution, as XP Investimentos is the largest broker dealer in Brazil in terms of shares and options traded on the BOVESPA.

In terms of Latin America, we have a team led by Alberto Bernal, one of the most respected strategists in the region, covering the various LatAm markets, which gives us an inside look at what is really happening in these countries. For 2017, we are looking at opening offices in different countries throughout Latin America which will effectively increase our capacity to absorb local information which is of high interest for our US investors.

What services are in highest demand by the US institutional clients?

In our view, clients are in search of fresh, up to date and objective information, the type of information that cannot be found in traditional research reports. We have been able to deliver this through corporate access meetings (XP Investimentos organized over 1,000 meetings in Brazil and 400 meetings in the US in 2016) and recently, through information specifically focused on the political world. XP Investimentos has recently opened an office in Brazil’s capital, Brasilia, and has hired a team of political analysts that offer minute by minute coverage, giving clients live updates and insights on what’s going on in the executive and legislative branches of government. At a time like this, when politics is the main driver of financial markets in Brazil, providing up to date political analysis adds significant value to our clients when making investment decisions.

Our clients covering Brazil and Latin America are also requesting a lot of two/three days bespoke trips where we assist them meeting with experts on different sectors of the economy, providing them with an opportunity to get a real local flavor on what is going on in the country. We have had trips to Brazil, Argentina etc.

You are also developing the wealth management division for Latin American clients in the US, which Latin American countries are you servicing?

XP Securities is servicing practically all of Latin America. In addition to receiving client referrals from XP Investimentos (which has approximately 150,000 active clients), we are taking advantage of a gap that we have identified in private wealth management segment in the US. In fact, over the past several years, American banks and broker dealers have been increasing their investment minimums in order to hedge their risk in Latin American clients as a result of problems experienced in Latin American countries. As a result, there is a significant number of clients that do not have an option of where to house their investments in the US. Additionally, there are many investment advisors/bankers that were let go as a result of the fact that a portion of their clientele had assets of US$ 250.000 to US$ 1 million, despite the fact that they also had a meaningful client base with assets from US$ 1 million to US$ 5 million. We are positioning ourselves to bring these bankers and investment advisors to XP and service their clients. We have exactly what it takes to service them: price, product and service.

What services are you offering to your wealth management clients?

In terms of products, we offer the industry standard such as equities, options, bonds, mutual funds, ETFs, structured notes and futures. Furthermore, we offer many non-traditional products such as hedge funds and private equity funds. For example, we were authorized to refer clients to 3G Capital, which offers highly sought-after and exclusive investment funds.

Another differentiating factor is what we call “Product Teams”. We currently have two main teams: one focused on equities and the other on fixed income. Each team is responsible for generating efficiency in their respective product in order to maximize profitability for clients. This structure is different than the industry standard where the trade execution desk assists advisors when a complicated client question arises. These teams work closely with our advisors, providing them information on flow, issuances issuers, etc., which facilitates advisors with clients.

Oppenheimer Makes Key Strategic Leadership Changes In Private Client Division

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Oppenheimer recently announced the retirement of Senior Vice President Tom Fritzlen after more than three decades at the firm and the appointment of Jim Lowe as Fritzlen’s successor.

Jim Lowe,who will assume Fritzlen’s responsibilities as part of the senior management team for Oppenheimer’s private client division, has held executive positions at multiple wealth management firms. Most recently, Lowe served as a branch manager at Oppenheimer’s lower Manhattan branch, all while managing a successful investment advisory practice. He was also an executive director for Josephthal & Co. Inc., where he oversaw operations at 14 branch offices.

In addition to these changes, Mark Traffordand Todd Wiggins have been named branch managers of Oppenheimer’s Seattle and Atlanta branches, respectively.

Switzerland Remained the Largest Destination for Offshore Wealth in 2015

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Global private wealthgrew sluggishly in 2015, with some markets seeing significant slowdowns, leaving wealth managers searching for innovative ways to meet the shifting needs of diverse client segments, according to a new report by The Boston Consulting Group (BCG). The report, Global Wealth 2016: Navigating the New client Landscape was released recently.

A Slowdown in Growth

Global private financial wealth grew by 5.2% in 2015 to a total of $168 trillion, according to the report. The rise was less than a year earlier, when global wealth rose by more than 7%. All regions except Japan experienced slower growth than in 2014.

Unlike in recent years, the bulk of global wealth growth in 2015 was driven by the creation of new wealth (such as rising household income) rather than by the performance of existing assets, as many equity and bond markets stayed flat or even fell. Assuming that equity markets regain momentum, private wealth globally is expected to rise at a compound annual growth rate of 6% over the next five years to reach $224 trillion in 2020. The number of global millionaire households grew by 6% in 2015, with several countries, particularly China and India, seeing large increases.

Offshore Wealth Management

The report says that private wealth booked in offshore centers grew by a modest 3% in 2015 to almost $10 trillion. A key factor was the repatriation of offshore assets by investors in developed markets. Offshore wealth held by investors in North America, Western Europe, and Japan declined by more than 3% in 2015. The annual growth of offshore wealth globally is expected to pick up through 2020, although at a lower rate than onshore wealth (5% versus 6%).

Among offshore centers, Hong Kong and Singapore saw the strongest growth (around 10%) in 2015. Offshore wealth booked in these domiciles is projected to grow at roughly 10% annually through 2020, increasing their combined share of the world’s offshore assets from roughly 18% in 2015 to 23% in 2020. Switzerland remained the largest destination for offshore wealth in 2015, holding nearly one-quarter of all offshore assets globally.

According to a global BCG benchmarking survey, an annual feature of the report, average revenue and profit margins declined for wealth managers from 2012 to 2015. This development underlines the need for wealth managers to seize the opportunities stemming from three major trends that have altered—and will continue to alter—the industry: tightening regulation, accelerating digital innovation, and shifting needs in traditional client segments.

Nontraditional Client Segments

The report says that two nontraditional client groups whose investment needs and size (population-wise) merit special attention are female investors—whose success as corporate executives and entrepreneurs (in addition to being the beneficiaries of inheritances and legal settlements) have raised their wealth levels significantly—and millennials (people born between 1980 and 2000), whose overall wealth accumulation is rising steadily. In 2015, women held an estimated 30% of global private wealth, with the share slightly higher in developed markets than in emerging ones. Yet just 2% of wealth managers surveyed by BCG said they considered women a specific client segment—fully investigating their investment needs and how they wish to be served—and had adjusted their service models accordingly. Similarly, 50% of wealth managers surveyed said they did not possess a clear view on how to address millennials in terms of service model, products, and overall approach.

The Investing Implications of British-Stay or Brexit

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According to Richard Turnill, BlackRock Global Chief Investment Strategist, the outcome of the June 23 UK referendum on whether to remain in the European Union could have far-reaching market implications in the near term.

“Betting markets imply a roughly 27 percent chance of a British-exit (or Brexit), but momentum has been building toward a leave vote, as evident in the chart below.” he writes on his company’s blog.

Other indicators suggest a higher probability of a Brexit and a much more uncertain outcome. Traditional polls point to a near 50/50 race, and comments on Twitter are tilted toward a Brexit, BlackRock’s analysis shows.

So, what would be the investing implications of a Brexit? Turnill believes that the U.K. and other European assets would likely bear the brunt of a leave vote. The chart above suggests the British pound could drop significantly in the event of a Brexit. “We would also expect to see U.K. equities (especially domestically exposed small- and mid-caps) decline under a Brexit scenario.” He mentions.

In addition, a leave vote would likely shock global markets. They believe risk assets — including stocks and credit — would suffer in the resulting risk-off environment, as concerns about political instability and a reversing globalization trend would lead to higher risk premiums. Peripheral European assets and the global financials and materials equity sectors would be especially exposed, according to their stress-test analysis. Political risk could also rise amid uncertainty over the succession to British Prime Minister David Cameron. BlackRock believes safe-haven investments would benefit from this situation.

What if the U.K. votes to stay? “We see risk assets rallying, safe-haven assets suffering, the pound getting a boost and market attention turning to the upcoming U.S. presidential election. The key for the next few weeks: Caution. We believe now is a good time to dial down equity and credit risk, and U.K. investors may want to put in place hedges against a potential Brexit outcome,” Turnill concludes.

62% of U.S. Adults Do Not Get Any Financial Advice

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The findings of the 2016 Planning and Progress Study, recently published byNorthwestern Mutual, show that the majority (62%) of U.S. adults are not getting any professional financial advice; and among those who are, many (43%) say their advisors don’t feel like long-term partners with a deep knowledge of their complete financial picture.

The study also found that nearly seven in ten Americans (68%) say that they do not have a trusted advisor who offers comprehensive lifetime financial planning; 45%of Americans do not know where to get the help they need as they move through life stages and need different financial solutions. Among those with a financial plan, 82% believe that their financial plan should be reviewed at least once every six months..

Among those who are getting professional advice only 56% say their current/primary advisor gives them an understanding of their complete financial picture; Only 43% say their current/primary advisor has a long-term commitment;Only 41% say their current/primary advisor provides tailored attention; And a third (32%) works with multiple different advisors to address different parts of their financial lives (e.g., retirement planning, investments, insurance).

The study seeks to provide unique insights into U.S. adults’ attitudes and behaviors towards money, financial decision making, and the broader landscape issues impacting people’s long-term financial security. It was based on an online study of 2,646 U.S. adults conducted from February 1-10, 2016. Data were weighted to be representative of the U.S. population (age 18+) based on Census targets for education, age/gender, race/ethnicity, region and household income.

For Old Mutual, Genuineness is the Key Factor when Investing in European Small Caps

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During Old Mutual’s second conference in Punta del Este, Uruguay, Ian Ormiston, Fund Manager for Old Mutual Europe (Ex UK) Smaller Companies Fund, defined his strategy as “a sensible fund which invests in a sensible mix of businesses, consistently providing a series of fairly high returns when compared with other funds in their category or against the benchmark.” A full bottom-up strategy, which invests in some 50 European small-cap companies, equally weighted at 2%, with sufficient market liquidity and which have pricing power and show growth potential.

For Ian Ormiston, the key factor is that companies are genuinely small cap companies: “For some fund managers, especially for those who have succeeded, the important thing is to achieve more assets, therefore small cap funds become small and medium cap funds. We want to buy companies that are genuinely small cap; the segment we seek is in the range of 1 billion to 1.5 billion. The reason is that it’s in this segment where the greatest opportunities lie, it’s the most imperfect segment in the market, and it’s where we will get the returns.”

As for the market outlook for European equities, Ian says that through the media we only become aware of the problems, the crisis in Greece, the probability of Brexit, Austria’s shift towards the radical right, the repetition of elections in Spain, the massive influx of refugees, etc.; while all this commotion favors the creation of opportunities for finding companies with good fundamentals at good valuation levels. “Europe is a rich continent with slow growth, with a GDP growth between 1.5% and 2%. It is not a dynamic economy, but there are pockets of growth. Especially in small-cap companies which have provided good returns over time. “

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When asked about the advantages of investing in small cap stocks versus the large cap within the European market, the fund manager mentioned three reasons: the first factor is the higher compounded growth in returns in this asset type, generally small cap sales grow 2% faster than sales of large caps. Secondly, the low coverage by analysts, European large caps have an average of 36 analysts covering each stock, while only 5 analysts cover each stock within the small caps segment. And finally, the third reason would be the high degree of family ownership in European businesses in comparison to that of the United States or United Kingdom. “We maintain a stock in the portfolio for a period of between five and seven years, as usually, a person who has founded their company remains in charge of the company for the next 30 or 40 years, so their interests are aligned with ours.”

For the strategy, Ian Ormiston selects those small cap companies that have sufficient liquidity and which are relatively easy to operate. He also seeks companies with established sales growth, a good product, and a clear market. “We avoid those companies with business models resembling a lottery ticket. We look for companies which still have many years of growth ahead, with a potential upside of around 30%. We then meet with Management to test whether their strategy is credible, their growth is sustainable and their restructuring plan is believable.”

Regarding ECB measures and their impact on the economy, Ian points out that the EU’s delay in taking action on monetary policy, as compared to the US or the UK, led to the growth in divergence of economic performance between EU Member states. But he admits that the situation has improved since Mario Draghi made his “Whatever it takes” speech in 2012. Although the new measures have no direct effect on European small caps companies, these measures will lower the cost of financing, encourage credit growth, and avoid further fragmentation of interest rates between core European countries and the periphery.

Finally, regarding “Brexit“, he admits that two of the companies in which the fund invests specifically mentioned Brexit as one of the main reasons that have affected sales. “The uncertainty itself will have an impact. The UK is currently very much connected to Europe. If investors begin to worry about the UK’s possible exit, it could be very negative for Europe by fostering debate in Italy, Spain, Ireland and Greece, where the population also questions the future of the Euro “.

Money Market Fund Reform: EFAMA Believes Final Agreement Should Find Right Balance Between Financial Stability and Economic Growth

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Last Friday, the Economic and Monetary Affairs Council of the EU approved the General Approach reached on MMFR at Council Working Party level. This General Approach followed an original proposal by the European Commission in September 2013.

The European Fund and Asset Management Association (EFAMA) is of the view that a well-functioning European market for MMFs has an important part to play in the European Commission’s flagship Capital Markets Union initiative. EFAMA, whose members manage both VNAV and CNAV funds, has from the outset indicated that a proportionate and balanced Regulation which ensures the viability of both CNAV and VNAV MMFs, can contribute to supporting alternative sources of financing to the real economy and financing European growth.

“We believe the agreement reached under the Netherlands Presidency, taking into account market realities, to be an improvement on crucial matters. We are nonetheless conscious that the magnitude of the MMF reform will require a major overhaul of the industry. We also believe that further work is necessary during the Trilogue discussions to safeguard current achievements but also to further ensure that the rules work in practice and secure the viability of all MMFs”.

Peter De Proft, Director General of EFAMA, commented: “Ultimately, EFAMA believes the final agreement should find the right balance between financial stability and economic growth. Ensuring the viability of MMFs as an alternative source of short-term financing with a crucial role to play in our capital markets is all the more important considering the unprecedented economic, political and societal challenges faced by the European Union today”.

The Impact of Britain’s Impending EU Membership Referendum on Fund Flows in the UK

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With the uncertainty generated around the outcome of Britain’s impending EU membership referendum, Thomson Reuters Lipper investigates if recent UK fund flows can reveal any insights into investor sentiment. Insights from Thomson Reuters Lipper follow below, with supporting data attached.

On mutual funds, examination of data on the U.K.’s Investment Association (IA) classifications (sourced via Thomson Reuters Lipper) shows an overall drop of 18% in total assets of the funds in all IA classifications and estimated net outflows of GBP 38 billion for the 12 months to May 31, 2016. January 2016 proved the worst month overall, with nearly GBP 16 billion of net outflows that month alone.

The largest IA sector (UK All Companies), with some 12% of all IA assets, has suffered a yearly net outflow of GBP 9.2 billion. In the last 12 months it has experienced only a single positive month of flows (July 2015).

The IA Sterling Strategic Bond sector has been worst hit as a proportion of its overall size in the U.K. market. With 4% of total assets overall, it has suffered nearly GBP 12 billion of net outflows to the end of May 2016, without a single monthly net inflow for the year.

Of the diversified categories the conservative IA Mixed-Asset 0%-35% has proven most resilient, with GBP 410 million of net outflows for the year to the end of May 2016. By contrast, the IA Mixed-Asset 20%-60% sector has suffered nearly GBP 5 billion of net outflows for the last 12 months.

Only four of the IA sectors have experienced more than GBP 1 billion of net inflows in the 12 months to the end of May: Property, Global Equity Income, Global Bonds, and Targeted Absolute Return. The latter sector has been the standout success story for the U.K. market for the last 12 months. It has collected nearly GBP 10 billion of net inflows. This is despite the corresponding average fund return of the sector being a negative 0.6% over the same period.

Are Bond Yields Forecasting Equity Weakness?

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Beware distortion in yield curves and discount rates. Last week was certainly a jittery one in equity markets, but in bond markets history was being made.

The yield on Germany’s 10-year government bond went negative for the first time ever. A Swiss government bond set to mature 32 ½ years from now also saw its yield go red. Bank of America Merrill Lynch offered a chart showing global interest rates hitting their lowest levels in 5,000 years.

What happens in the world of fixed income matters a lot to equity portfolio managers: It gives us valuable signals about what’s going on in the macro environment, and hence the potential for companies to grow revenues and earnings; and by providing us with discount rates it directly influences how we value those potential earnings.

So what are these historic numbers telling us today?

‘Brexit’ Risk Has Jolted Markets…
On the macro side there was certainly a bout of risk aversion last week. As bond yields plummeted, gold rallied to test the $1,300/oz. level. Last Monday the VIX Index rocketed from 17 to 23.

Much of this seemed to come down to a spate of opinion polls showing momentum for the “Leave” camp in the U.K.’s referendum on membership in the European Union. Brad Tank, Erik Knutzen and I will discuss the longer-term implications of that vote in a special edition of CIO Weekly Perspectives this Friday, so keep an eye out for that.

… But Equities Are Still in a Rally
For now, it’s enough to point out that this binary risk may well be priced back out of markets by this time next week. In the meantime, while bonds trade with historic low yields, U.S. equities are still only down around 2.5% from their recent high, itself close to an historic level.

How do we make sense of these apparently contradictory market signals? Is one of them spectacularly wrong in its growth forecast, and if so, which is it—the bond market or the equity market?

This is the wrong question to ask in the post-financial crisis world. Instead we should ask about the extraordinary forces causing these fixed income records to tumble.

U.S. Curve Shaped by Fed and Non-U.S. Investors
Take the shape of the yield curve, for example. A flat or inverted curve tends to make investors anxious: A flat or inverted spread between the two-year and 10-year U.S. Treasury yield has been quite a reliable forward indicator of a U.S. recession over the years.

Today that spread is around 90 basis points. A year ago it was as steep as 175. But this move has been not only, or even mainly, about investors reducing their long-term growth expectations. Indeed, part of it has been a move upwards at the short end of the curve as the Federal Reserve has talked about normalizing the Fed Funds rate in response to the U.S. economic recovery.

At the long end, rather than a new sense of economic gloom, yields have declined due to demand from investors in the Eurozone and Japan, where rates are low or even negative. In comparison, long-dated U.S. Treasuries look relatively attractive. There is simply a shortage of high-quality yielding assets in the world.

In short, we shouldn’t assume that bond markets are forecasting a hostile environment for equities.

Low Discount Rates Make Equities Look Expensive
We should also think about how low risk-free discount rates affect our views on equity valuations. Through the simple mathematics of discounted cash flow models, lower discount rates lead to higher P/E ratios for the same level of future earnings. Higher levels of inflation and interest rates are one important reason why the average P/E ratio for the S&P 500 Index was around 15x from the 19th century until 2007, and 16.5x between 1950 and 2007. In the type of low-rate environment we have experienced in more recent years, the average has been 17-19x.

To be clear, we still caution that current equity market valuations represent optimistic expectations for earnings growth over the next 12 months—but we do not think they represent “irrationally exuberant” expectations, as a cursory look at relative value versus bonds might suggest. Bond markets still provide useful signals to equity portfolio managers, but we need to be clear about what they are—especially when those markets rewrite the history books as vigorously as they are at the moment.

Neuberger Berman’s CIO insight by Joseph V. Amato