Global equity markets rallied impressively in the quarter, pushing some year-to-date numbers into double-digit territory only halfway through the calendar year. The rally was evenly felt across the planet, with the S&P 500 Index up 8.6%, the MSCI EAFE Index up 5.2% (USD), and the MSCI EM Index up 5.1% (USD). For the year-to-date period, the numbers are 15.3%, 8.8%, and 7.4%, respectively.
The re-opening or reflation trade, which favors more cyclical, value-y names – gained steam in the early part of the quarter but reversed course and then some in June. On the quarter, the MSCI ACWI Value Index underperformed its growth counterpart by 514 bps; the reversal was more pronounced in the U.S. with the Russell 1000 Value Index underperforming growth by 672 bps. Some may point to slightly moderating inflation expectations as the root cause of this reversal. But no matter the cause, the value reversal, which had started in earnest back in early November of 2020, took a breather.
Ten-year Treasury yields were down a notable 29 bps on the quarter, as the yield curve flattened. Five-year breakeven inflation rates moderated on the quarter, as the Fed continued to jawbone on the transitory nature of the current inflation spike. The tension is palpable between the disinflation camp and the inflationistas. The disinflation camp still points to globalization, aging demographics, the failure of unprecedented money printing to generate inflation, swelling debt loads, uneven global normalization, and the threat of COVID-19 variants to paint a picture that says, “We’re not out of the woods yet.” Many in the markets, however, paint a different picture – one of disrupted supply chains, rising commodity prices, infrastructure needs, and massive fiscal spending and social programs aimed at boosting lower-wage incomes. This push-me-pull-you dynamic is not going to be decided by any singular data point, but inflation fears certainly subsided a bit this quarter.
Credit markets also rallied with the general risk-on feel of Q2, with the Bloomberg Barclays Aggregate Index up 1.8%, the BoA Merrill Lynch U.S. High Yield Index up 2.8%, and the JPM EMBIG Index up 3.9% on the quarter. The ICE BofA Option-Adjusted Spreads are the tightest we’ve seen since the spring of 2007, right before the financial crisis debacle.
During the quarter, the real earnings yield on the S&P 500 turned negative and hit a 40-year low (this didn’t even happen during the TMT bubble of the late 1990s). Combine that with long-standing negative real yields on Treasuries, throw in some of the tightest credit spreads in history for good measure, and it is difficult to get excited about traditional asset classes and their prospects.
It gives us no pleasure to remind our clients that U.S. stock valuations, by almost any backward or forward-looking measure that we’ve come up with, are at levels that concern us. If one must own U.S. stocks, however, as many institutions and advisors do, we suggest leaning into value and cyclicals while maintaining a quality bias.
Meanwhile, many among the Twitter-sphere and other social media discussions have expressed frustration with GMO’s bearishness. Many have also wondered aloud whether GMO is not giving enough credit to some of these high-growth, new-business-model “disruptors.” First, we have all sorts of models that take current optimistic growth forecasts into account. Many individual companies are deserving of their current high multiples – we absolutely concede that somewhere in the global growth basket sits the next Amazon. Unfortunately, they’re also ALL being priced that way, and for us, that is a bridge too far.
We are loath to recommend a traditional 60/40 mix. There will come a day when global equities and government bonds are fairly valued and should deliver a “normal” real rate of return. On that day, GMO will be the first in line to tell you to own that traditional mix. Today, however, is still not that day.
But our forecasts are not all doom and gloom – in fact, they’re far from it. Emerging market value, which has rallied strongly in the past 12 months with the MSCI EM Value Index up 41%, is still priced to deliver quite decent relative and absolute returns. Japan small value stocks are also quite attractive as they trade at some of the widest discounts we’ve seen in over twenty years; combine that with strong evidence of more disciplined capital allocation and rising ROEs, and Japan small value is an area that – dare we say it – we’re actually excited about.
Furthermore, the valuation spread between global value and growth remains at some of the widest levels we have seen in our careers, and there are all sorts of interesting ways to exploit this dislocation. Importantly, valuation spreads across asset classes more broadly in rates, FX and commodities represent huge opportunities in the non-traditional long/short space. Different impairments from, and different government and Central Bank policy responses to COVID and its economic devastation have left cross-sectional rate FX plays attractive. Merger activity is healthy, with a robust pipeline and a variety of deals across structures and industries. With multi-strategy hedge funds distracted by the SPAC space, there’s also less capital chasing these deals. There’s simply too little capital chasing too much deal volume.
Our main message is thus: in a global growth bubble, we are advising clients to do three things: 1) exploit the bubble with an equity long/short strategy, 2) avoid the bubble by investing in alternatives, and 3) concentrate assets away from the bubble in emerging market value, Japan small value, cyclicals, and quality. For fixed income, keep duration shorter than normal, and use active management in the credit space, where interesting pockets of dislocation remain ripe for the picking while spreads are tight.