Keep calm and avoid the frothiness
With the US market back at dotcom levels of irrational exuberance, Brian McCormick, Equities Analyst, Value Equities, explains why it’s useful to look at lessons from the past.
It’s easy to get caught up in the frothiness of the market and the fear of missing out. So, at times like these, it can be useful to look back at examples from financial history. They provide comfort to those sitting out the hype.
In Walter Bagehot’s unlikely 1873 bestseller ‘Lombard Street: A Description of the Money Market’, you’ll find more than a few such examples to calm the nerves. Among them is an account of the speculative bubble of 1688. Much like today, the bubble was caused by a surplus of savings. A period of growth in household savings had bid up the price of real estate and credit was abundant.
In the years preceding the bubble, savers faced an uninspiring rate of interest, even from marginal borrowers. There was an unknown amount gold and silver hidden away in sock drawers and vaults, which created some of the FOMO necessary for highly speculative behaviour. These savings could, it was reasoned, pour into investable assets – if you didn’t get in today, you would miss out on the day’s wealth generating assets and permanently impair your own position in society. Bagehot describes how, “The natural effect of this state of things was that a crowd of projectors, ingenious and absurd, honest and knavish, employed themselves in devising new schemes for the employment of redundant capital’, as ‘a crowd of companies, every one of which confidently held out to subscribers the hope of immense gains, sprang into existence”. Many of the investors during that speculative period were wiped out, something today’s investor in the latest concept stock IPO or SPAC deal would do well to remember.
The fear of a permanent loss of wealth in an era of gold and silver coinage may seem absurd to today’s investor. We are now asked to place our faith in fiat currency from central banks whose credibility seems more ‘transitory’ by the day. But there are several interesting lessons we can lean on. The first, is that a boom in savings will invariably lead to a boom in hustlers clambering to take them. The second, is that a good idea and a good investment are not one and the same. Many of the businesses promoted during the 1680s were in rapidly growing markets such as low-cost education, glass bottles, and insurance. Those markets did grow rapidly during the centuries that followed. But when too much capital chases an idea, when the ethics of the promoter are questionable, or the legal structure provides inadequate protection to the shareholders, the returns for the underlying investor are likely to be severely lacking. Perhaps the most surprising lesson from this bubble though is how short the market memory proved after the fact.
You might have assumed that such a bubble would leave a scar on the markets – maintaining a healthy scepticism and risk aversion in market participants for several decades to come. But within twenty years of the collapse, shares in the newly founded South Sea Company began to climb, and with them grew one of the world’s most famous speculative manias.
Why is that relevant for us today? The US market is, by many metrics, now trading at levels of irrational exuberance beyond those witnessed in the dotcom bubble, which burst just 20 years ago. Every valuation metric has its flaws (earnings, cashflow, book value etc.), but in the long run, it should be uncontroversial to believe in some relationship between the price of a large company and how much stuff they manage to sell. Over 70 companies in the S&P 500 Index are now trading above 10x price to sales. On the Value Equities team, we find ourselves revisiting the infamous quote from Scott McNeally, former CEO of Sun Microsystems, in the aftermath of the DotCom crash. In short, “At 10 times revenues…. what were you thinking?”
Bank credit at a crossroads
Luca Evangelisti, Fund Manager and Head of Credit Research, Fixed Income, discusses the outlook for financial credit including contingent capital, or CoCos.
The current year has been positive for financial credit and equities from a fundamental but also a valuation perspective. At the start of the Covid crisis, there were concerns and significant provisioning against potential losses for the banking sector. There was also unprecedented regulatory and government support for the economy, which kept corporate default levels at manageable levels.
Banks were quite resilient, having come into the pandemic in a strong position from a capital and liquidity perspective. There were no defaults in the banking sector in Europe.
We came into this year following three years of substantial equity underperformance compared to financial credit. From 2018 to 2020 bank equity lost more than 37% in aggregate in Europe. This year has been a reversal, with bank equity outperforming financial credit and the wider market. This is a result of the removal of the dividend ban, improved economic growth data and the outlook for rising interest rates, which support more optimistic earnings outlook — a key driver for equity valuations.
Now we’re at a crossroads. The support measures for the economy are being removed and this leads to some concerns going into 2022. The inflation debate is becoming crucial. It appears that inflation will last longer than initially expected, into the first part of next year, especially in the US and UK. This will put pressure on central banks to act, and they will have to be careful not to harm the recovery, which is still incomplete, especially in Europe.
From a credit risk perspective, we’re less concerned about systemic volatility. Taking the lessons learned in 2020 — the regulatory playbook and how the crisis was dealt with — we think this would be deployed again in case of further stress.
On a valuation point of view, we remain cautious about the most senior part of bank credit. This is because the yields are quite low and not enough to counterbalance higher inflation and negative real yields. In addition, banks may have to issue more at the senior level next year.
In contingent capital, or CoCos, the yields are still attractive and well in excess of generic high-yield credit, with a with a much better risk profile. Also, the supply outlook is supportive to valuations given we will probably see negative net supply in 2022. Fundamentally, European banks have a strong capital position, well above the minimum requirements therefore should be able to absorb well even a potential deterioration in asset quality during the year.
We also see opportunities in credit of less well-known banks and financial corporates, where the bonds are not priced to perfection, like most global banks (G-SIBs), and they offer a substantial pick up when compared against generic high yield credit.
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