With the yields on safe government and investment-grade bonds remaining low in the current environment, investors continue to seek out sectors of the stock market that can replace income and provide some defense if economic growth were to turn sour. The worry, though, may be that some of these sectors are becoming richer and dearer as more investors pile into the trade.
Earlier this month, the International Monetary Fund (IMF) estimated that the amount of government and corporate bonds with negative yields had increased to $15 trillion. This, in part, has been the byproduct of looser financial conditions with more central banks lowering interest rates to cushion their economies from a potential slowdown.
The so-called “lower for longer” interest-rate environment in fixed income has led institutional investors to reach for yield, adding riskier securities to their portfolios. It has also resulted in overstretched valuations in some equity markets. The IMF made note of Japan and the U.S., for example.1
So, is there really an argument to be made that more investors are shunning fixed income for riskier stocks? Denmark’s Saxo Bank in an Insights post points out that during periods where there is a significant increase in the amount of negative yielding bonds, a “substitution effect” takes hold among investors. Institutional investors rethink their portfolios, add high-dividend paying stocks as substitutes for bonds, and (or) move into low-volatility stocks for safer risk-adjusted returns.
The result, however, has been higher valuations and worries that investors are piling into a crowded trade. Saxo Bank says low- or minimum-volatility factor stocks in the U.S. trade at roughly a 29% valuation premium to the S&P 500, which also trades at a 40% valuation premium to global equities, excluding North America.
This substitution effect, then, “comes with risk as the move makes the minimum volatility factor trade more crowded and [to] such an extent that some observers of equity factor returns are sounding the alarm,” Peter Garnry, Saxo Bank’s head of equity strategy, said in the October 22 Insights post.2
More About the Low-Volatility Trade
Low-volatility factor investing cuts against the grain of thinking that to get higher returns you have to take on higher risk. This thinking was challenged in the 1970s with research showing that less volatile portfolios, based on an analysis of U.S. stock and bond markets from 1926-1971, delivered higher average returns than riskier portfolios over the long term.
According to research from S&P Dow Jones Indices, low-volatility indexes used as benchmarks for low-volatility strategies historically tend to post higher risk-adjusted returns across a number of time horizons, regions and market segments.
In the U.S., the S&P 500 Low Volatility Index had annualized returns of 11.16% in the period from December 1990 through May 2019, compared to 10.08% for the S&P 500. Investors also would have been rewarded more for the risk of owning the low-volatility strategy, essentially earning a higher return for each dollar invested. At 1.03, the S&P 500 Low Volatility Index had a higher risk/reward ratio than the S&P 500’s 0.71.3
These days, low-volatility strategies are quite popular, particularly given the view that they are less vulnerable and more of a risk-reduction play during a cyclical downturn. While the U.S. and global economies have yet to tip into recession, investors haven’t been waiting to pile into these strategies, fueling concern in some circles that the money flows have pushed valuations beyond what stocks in the sector should be worth.
Sensitivity to Interest Rates
Some of the sectors considered to be among the low-volatility crowd like utilities and real estate investment trusts (REITs) are also thought of as bond proxies. That’s because they pay higher dividends than other sectors of the stock market. But they can be among the sectors to get hit when interest rates rise.
Tina Byles Williams, chief executive officer at FIS Group, told Bloomberg that low volatility is a crowded trade and isn’t without risk. “If you have a normal cyclical downturn, then a low volatility strategy is appropriate but low volatility tends to be high duration,” as prices would decline more when interest rates rise. Higher interest rates mean the trade could go “horribly wrong,” she said in the Bloomberg report.4
Garnry at Saxo Bank said in another Insights post that the biggest risk to stocks in addition to an economic slowdown is “an interest rate shock.” Ironically, that could occur if governments “finally go all-in” on fiscal expansion to reignite global growth, thus resulting in higher inflation.
“With equity valuations pumped up due to low interest rates a cocktail of fiscal expansion, higher inflation and higher rates could become toxic for real rate returns on equities,” he said.5
1-Adrian, T. and Natalucci, F. (2019, October 16). Lower for Longer: Rising Vulnerabilities May Put Growth at Risk. International Monetary Fund. IMFBlog. Retrieved from: https://blogs.imf.org/2019/10/16/lower-for-longer-rising-vulnerabilities-may-put-growth-at-risk/
2-Garnry, P. (2019, October 22). Are equities right this time? Saxo Bank. Retrieved from: https://www.home.saxo/insights/content-hub/articles/2019/10/22/are-equities-right-this-time
3-Preston, H. (2019, June 11). Four Decades of the Low Volatility Factor. S&P Dow Jones Indices, Indexology Blog. Retrieved from: https://www.indexologyblog.com/2019/06/11/four-decades-of-the-low-volatility-factor/
4-Lee, J. (2019, October 10). Stock Traders Pay Biggest Premium to Shun Volatility in 41 Years.” Bloomberg, as posted in Yahoo Finance. Retrieved from: https://finance.yahoo.com/news/recession-angst-ramps-premium-calm-122302179.html
5-Garnry, P. (2019, October 21). Higher equities will lead to dangerous valuations. Saxo Bank. Retrieved from: https://www.home.saxo/insights/content-hub/articles/2019/10/21/higher-equities-will-lead-to-dangerous-valuations
Investment advisory services are offered through BCJ Capital Management, LLC., an SEC Registered Investment Adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed, and past performance is no guarantee of future results. For specific tax advice on any strategy, consult with a qualified tax professional before implementing any strategy discussed herein. BCJ FG 19-159