Bullish mood across markets leaves investors with a dilemma

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An unmistakable bullishness is breaking out among investors on the outlook for equities. By some measures, it might be even tipping over into exuberance.

Despite a global economy still reeling from the pandemic and uncertainties over the rollout of a Covid-19 vaccine, fund managers are looking through the gloom to better times ahead.

The latest monthly survey of 190 global fund managers overseeing a combined $526bn in assets by Bank of America this week identified a sharp rotation into equities, small-cap stocks and emerging markets.

Exposure to equities has climbed to its highest level since early 2018 among fund managers with two-thirds of them believing that an “early-cycle” phase has dawned, noted BofA. The amount of cash that investors are keeping in their portfolios fell to 4.1 per cent, according to the bank, similar to the level in January before coronavirus rocked global financial markets.

Michael Hartnett, chief investment strategist at BofA, said this week the decline in cash levels was often a signal of investor exuberance. “We are starting to see some extreme measures of sentiment, as cash levels are low and equity allocation is high,” he said.

However, given the current high starting point for many publicly traded assets, returns over the coming decade look a lot less fulfilling. 

Past new economic cycles were accompanied by financial markets nursing deep lasting scars in the form of high yields on risky types of debt and low equity valuations.

Thanks to aggressive central bank and government support earlier this year and now the promise of vaccines, both the equity and corporate bond markets have pulled forward a big chunk of their future market performance.

The average interest rate on US junk bonds recently fell below 4.8 per cent, setting a new all-time low for the lowest quality rated corporate credit, according to the ICE Bank of America index. Among equities, US small-caps and industrial shares — classic barometers of future economic expectations — this week both exceeded their previous all-time peaks set in 2018 and earlier this year respectively. 

The pace of the market rebound has been astonishing when looking back at past cycles. “It usually takes four to five years for US equity markets to lift small-caps and industrials to new all-time highs after a recession,” said Nicholas Colas at DataTrek.

This pandemic legacy of a low starting point for bond yields and extended equity valuations does heighten the difficulty of saving for retirement and meeting pension obligations.

The latest annual forecasts on long-term capital market returns from JPMorgan Asset Management lays out the challenge.

“A plain vanilla 60/40 portfolio of global equities and US bonds is now projected to provide an annual return of just 4.2 per cent over the next 10 to 15 years compared to 5.4 per cent a year ago,” said David Kelly, chief global strategist at JPMorgan Funds. Since 1980, the return on such a portfolio in the US has been a compound annual growth rate of 10.2 per cent.

Chart shows total return on MSCI All World index, compound annual growth rates (%) showing investors are bracing for lower equity returns over the next decade

Over at DWS, the asset manager estimated an annual nominal return of 5 per cent from the MSCI All Country World Index during the next decade, and noted this represented “about half of what investors have received over the past decade”.

Such an outcome has spurred a rush towards alternative assets and private markets. Estimates of future returns from private equity, real estate and global infrastructure look better for investors willing to lock money away for up to a decade. One downside is a far greater dispersion of performance in funds holding illiquid private assets than what investors experience in public markets.

For those unwilling or unable to seek greater exposure to alternative assets, an extended period of ultra low bond yields means owning more equities.

Line chart of world healthcare equities showing it is profits, not valuations, that support healthcare stocks

But investors should think hard about what kind of companies and sectors have capacity for expanding during the 2020s. UBS Global Wealth Management advocates looking at fintech and greentech with the global rollout of 5G technology boosting the growth of robotics, autonomous vehicles, artificial intelligence, data analytics and cyber security.

It also points to healthcare. UBS estimates that the global population aged above 65 will expand “60 per cent to 1bn by 2030”. This will require more spending on healthcare and related technology.

“Unlike tech, the healthcare sector rally is being driven by profits, not by a valuation uplift,” said Dhaval Joshi, chief strategist at BCA Research. “The long-term valuation stars for healthcare are looking attractive.”

Among the 20 main Euro Stoxx 600 groups, healthcare tops the charts with a 15.6 per cent share. In the US, the sector tops the scale among US small-caps in the Russell 2000 index at almost one-fifth, while the S&P 500 weighting has been stuck around 14 per cent in recent years.

If healthcare expands further from here, then it might in itself help share markets beat the current lowball estimates of future returns.

michael.mackenzie@ft.com

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