Global equity markets rallied impressively during the quarter, pushing some year-to-date numbers into only double-digit territory in the middle of the calendar year. The recovery was felt evenly across the globe, with the S&P 500 Index up 8.6%, the MSCI EAFE Index up 5.2% (USD) and the MSCI EM Index up by 5.1% (USD). For the period since the start of the year, the figures are 15.3%, 8.8% and 7.4% respectively.
Reopen or reflation trading, which favors more cyclical and y-valued stocks, gained momentum early in the quarter but reversed course and then some in June. Over the quarter, the MSCI ACWI Value index underperformed its growth counterpart by 514 basis points; the reversal was more pronounced in the US, with the Russell 1000 Value Index underperforming growth by 672 basis points. Some might point to a slight moderation in inflation expectations as being at the origin of this reversal. But whatever the cause, the reversal in value, which began in earnest in early November 2020, has come to a halt.
Ten-year Treasury bill yields fell 29 basis points in the quarter as the yield curve flattens. Five-year break-even inflation rates moderated during the quarter as the Fed continued to criticize the transient nature of the current inflation spike. The tension is palpable between the disinflation camp and the inflationists. The disinflation camp always points to globalization, an aging population, the failure of unprecedented money printing to generate inflation, rising debt, uneven global normalization and the threat of variants of COVID-19 to paint a picture that says: still woods. Many in the markets, however, paint a different picture – of disrupted supply chains, rising commodity prices, massive infrastructure needs and budget spending, and social programs aimed at raising lower incomes. wages. This push-me-pull-you dynamic won’t be decided by a single data point, but inflation fears have certainly eased a bit this quarter.
Credit markets also recovered with general risk sentiment in the second quarter, with the Bloomberg Barclays Aggregate Index up 1.8%, the BoA Merrill Lynch US High Yield Index up 2.8% and the JPM EMBIG index up 3.9% over the quarter. The spreads adjusted to the ICE BofA options are the tightest we have seen since the spring of 2007, just before the debacle of the financial crisis.
During the quarter, the actual earnings performance of the S&P 500 turned negative and hit its lowest level in 40 years (this didn’t even happen during the TMT bubble of the late 90s). Combine that with long-standing negative real yields on Treasuries, add some of the tightest credit spreads in history for good measure, and it’s hard to get excited about traditional asset classes and their outlook.
It does not do us any pleasure to remind our clients that the valuations of US equities, by almost any retrospective or forward measure that we have proposed, are at levels that we are concerned about. However, if one must hold American stocks, as many institutions and advisers do, we suggest to favor stocks and cyclical stocks while maintaining a quality bias.
Meanwhile, many in the Twitter sphere and other social media discussions have expressed frustration with the downtrend in GMOs. Many also wondered aloud if GMOs were not giving enough credit to some of these high growth “disruptors” and the new business model. First, we have all kinds of models that take into account the current optimistic growth forecasts. Many individual companies deserve their current high multiples – we absolutely recognize that somewhere in the basket of global growth is the next Amazon. Sadly, they are ALL priced that way too, and for us it’s a bridge too far.
We are loath to recommend a traditional 60/40 blend. There will come a day when global stocks and government bonds will be valued at their fair value and should offer a “normal” real rate of return. On that day, GMO will be the first to tell you about owning this traditional blend. Today, however, is still not that day.
But not all of our forecasts are pessimistic – in fact, they are far from being. The value of emerging markets, which has recovered strongly over the past 12 months with the MSCI EM Value index rising 41%, is still valued to offer fairly decent relative and absolute returns. Low value Japanese stocks are also very attractive as they trade at some of the biggest discounts we’ve seen in over twenty years; Combine that with strong evidence of more disciplined capital allocation and rising ROE, and small value in Japan is an area we dare say we are really passionate about.
Also, the valuation gap between global value and growth remains at some of the widest levels we’ve seen in our careers, and there are all kinds of interesting ways to exploit this dislocation. It is important to note that valuation spreads between asset classes more broadly in rates, currencies and commodities represent huge opportunities in the non-traditional long / short space. Different depreciations and different government and central bank policy responses to COVID and its economic devastation have made cross-rate games attractive. Merger activity is healthy, with a strong pipeline and a variety of transactions across all structures and industries. With multi-strategy hedge funds distracted by the PSPC space, there is also less capital seeking out these deals. There is simply too little capital for too much trading volume.
Our main message is therefore: in a global growth bubble, we advise clients to do three things: 1) exploit the bubble with a long / short equity strategy, 2) avoid the bubble by investing in alternatives, and 3) focus assets away from the emerging market value bubble, small Japanese value, cyclicals and quality. For fixed income securities, keep the duration shorter than normal and use active management in the credit space, where pockets of attractive dislocation remain ripe for the pick while spreads are tight.