Tuesday, December 8th, 2015

Default Risk and US Earnings

This is one of those simple, uncomplicated weeks when the models deliver a clear signal which is easy to interpret and in accordance with the way we view the current situation. We post the usual caveat about the danger of believing the evidence one agrees with and ignoring anything which is contradictory. But the signal is important in its own right and deserves to be discussed, even if other investors reach a different conclusion.

In our US asset allocation model, US High Yield bonds have fallen from #4 to #8 (out of 9) over the last two weeks. For some time they have been our least favourite fixed income category and have been doing worse than Treasuries, EM sovereign debt in US$ or Investment Grade, but in the last two weeks they have hit a new two-year low in terms of their rating relative to all fixed income. This is enough to send them almost to the bottom of the ranking in our global asset allocation model, with only EM Equities below them. Admittedly this model does not include commodities, but the situation is pretty bad when US dollar-denominated bonds cannot produce better risk-adjusted returns than overseas equity markets denominated in foreign currencies which are falling against the US dollar. The drop down the ranking is entirely a function of High Yield weakness rather than equity strength. The overall equity weighting has hardly changed.

In absolute terms, the weakness in High Yield has been caused by further problems in the Energy sector. But relative to the rest of the High Yield universe, Energy has actually seen a slight increase in its weighting, which implies that other sectors are starting to fall in its direction. The main culprit is Materials, but Industrials and Utilities look as though they may be starting down the same path. Any sector which makes Energy look less than completely toxic in the current conditions must itself be pretty bad. The obvious explanation is that investors have realised that there may be a material increase in default rates in 2016 and that there is no reason why this has to be confined to the Energy sector. Even if the scale of the defaults cannot be forecast with any precision, the risk that they will rise has to be factored into current prices. This is no longer a theoretical valuation exercise.

We think this has important medium-term implications for US earnings forecasts. For many months we have pointed to the wild implausibility of consensus estimates for the S&P 500 – currently 9% growth for 2016 and 12% for 2017. Much of this is based on hopes for a recovery in the Energy sector, but in the wake of recent falls in the oil price this looks less and less likely. So too, does a recovery in the earnings of the Materials sector in the light of other commodity-price declines. At the very least the recovery will have to start form a lower base. And now our High Yield model suggests that analysts may also have to downgrade their estimates for Industrials and Utilities.

All this supports our view that US Equities are unlikely to produce risk-efficient returns in the near future. They may beat Treasuries and other fixed income categories, but not by enough to justify the extra risk of holding them. If the US High Yield suffers across several sectors, it is unlikely to suffer alone.

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