Saturday, July 27, 2013

Brace Yourself for Mediocre Returns, Part 1 of 2


While Wall Street analysts debate the next market turn, far too little effort is being put into understanding the longer-term outcomes likely from various asset classes.  Though this is a more precise and, arguably more important, exercise than the one they choose to pursue, it remains a neglected area of research.  The bad news is that even under the most optimistic default and recovery scenarios, returns from nearly every fixed income segment will barely breach 4% in the coming decade.  Investment-grade segments will struggle to return to reach a “3-handle”.  Equity returns will be better, but that’s a relative comparison, and returns from most developed equity markets will struggle to crack 5%, with European markets faring somewhat better.  

In my previous posting, I identified a little talked about risk to corporate earnings – the substantial prop to margins provided by the Fed-created low interest rate environment.  While it is important to understand that this risk exists and its magnitude, it does little to identify when the risk becomes a market issue.  It is in this regard, Investors and Wall Street Analysts spend untold hours and countless dollars in their efforts to forecast short-term market returns.  Yet in spite of these efforts, in nearly 30 years in this industry, I have yet to meet anyone who has been able to do this successfully and consistently – this author included.  At the same time, I have seen more than a handful of practitioners who have been able to fairly accurately determine long-term returns from various fixed income and equity markets.  It is ironic then that despite these long-term forecasts being both more accurate and ultimately more important to investors such as endowments, foundations and corporate pension committees, greater efforts continue to be devoted to analysis based on short term market twists and turns.
 
This posting and the next are for those willing to look beyond the coming quarter.  Using a model I originally developed in the late 1990’s, I provide what I believe to be reasonably accurate return projections for fixed income and global equity market over the coming decade, along with the methodology for doing so.  Since its introduction, this approach has quite accurately called market outcomes.

Let’s start with fixed income markets.  As you know, a bond is a fairly simple instrument with returns accruing to just four factors: the price paid, the coupon payments received, the reinvestment of those coupons and the ultimate return of principal.  Taking each in turn, we know the price paid.  We also know the coupon payment as it is contractual in nature.  The reinvestment return of these coupons is unknown; however, as I will demonstrate below, even an immediate, radical move in interest rates will not dramatically change the overall return of a bond over its lifetime.  Finally, while return of principal to a single bond may be uncertain, when looking at the broader market of bonds of similar ratings, historical experience can provide a reasonable guide as to default and recovery rates.  Putting these together, estimating long-term bond returns is a very straight forward process.

Let’s use ten-year US Treasury notes as an example.  At July 21st, you could buy a ten-year government security with a maturity of May 15, 2023 for a price of $93.64.  That note will pay a semi-annual coupon at an annual rate of 1.75%.  At maturity, an investor will receive $100 and along the way, twice yearly coupon payments of $0.875 (per $100 value).  While we do not know the rate at which those coupons will be reinvested, even if we assume rates rise by 500 basis points before the first coupon payment is received (to 7.48% across all maturities), the total annualized return from this note will rise only to 2.96% over the ten year period.  Conversely, if rates fell to zero and an investor received no return at all on the coupons, the ten year total annualized return on this note falls only to 2.29%.  Thus, assuming no default, one can not realistically expect anything other than a return of between 2.29% and 2.96% from buying a ten-year US government note today.  Another way of looking at this is, assuming no risk of default, the best approximation of the long-term return on a bond is probably just its current yield (on the UST, currently 2.48%).

Looking at other developed government bond markets (G-7 plus Australia and Spain), we note the 10-year yields between 0.78% (Japan) and 4.60% (Spain).  Assuming no risk of default, these again are the best estimate for ten-year local currency returns. 

Source: Bloomberg

Of course, given the recent experience of Greece and on-going concern across the Eurozone, zero chance of default might not be the best assumption.  If one wanted to insure themselves against default risk, we can look to the Credit Default Swap market to gauge the costs.  Higher yielding markets such as Spain and Italy currently have annual “insurance” costs of 3.06% and 3.08%, respectively.  Perceived “safe” markets like the US and Germany have lower insurance costs of 0.41% and 0.65%, respectively.  Calculating the “net” return with insurance, we see an expectation for ten-year returns between 2.90% (Australia) at the high end and -0.46% (Japan) at the low end.
















Government markets are not the only fixed income game in town.  Lower rated corporate credits, mortgage securities and the like broaden an investor’s opportunity set.  Still, like the sovereign bond markets, the current yield on these instruments, less an assumed default and recovery rate, makes for the best long-term expectations of their likely returns.  However, since default and recovery rates are uncertain, it is best to examine these markets using scenario analysis, tweaking each of these two variables.

While there are many segments within the broader fixed income universe, for the purposes of this posting, I have chosen to project returns for US High Yield, European High Yield, Emerging Market Foreign-Pay Sovereign and US Investment Grade segments – all fairly liquid markets.  Current Yields and Spreads are shown below.


US High Yield
Euro High Yield
EM Sovereign
US Inv Grade
Current Spread
4.45
5.28
5.06
2.05
Historic Spread
5.24
6.42
4.30
1.95
Current Yield
6.01
5.85
7.66
3.87
Source: BofA Merrill Lynch, Brett Gallagher Calculations

Once again, assuming no default, Current Yield is our best guess at the long-term return from the various fixed income segments.  However, as there is some realistic level of default expected in each of these riskier pools, building a sensitivity analysis around the historic default level and recovery rates makes sense and is detailed in the tables below. 

For this analysis, I have turned to data gathered by Moody’s Investors Service which examines cumulative 10-year default percentages beginning annually in 1970.  I then convert this cumulative figure into an annual one and plug the median default experience (noted by red font), the worst 10-year default experience, the best 10-year default experience and the 25th and 75th percentile default experience.  Because of the longer history of the US data, I use that experience for other speculative markets as well (note: using a common data set with an inception date of 1983, European High Yield and EM Sovereign Debt actually have lower default rates than the US Universe over the common period – in the case of sovereign debt, about half that of US Corporates, though the range of outcomes is also wider). 

Default rates are calculated using Moody’s study of Cumulative 10-Year default rates over the period 1970 to 2010.  Following the cumulative default outcomes, in parenthesis, I show the annual equivalent default that results in the cumulative figure and that is used in the sensitivity tables below.


Baa-Rated
US, Euro, EM Sovereign
Worst Case
10.34% (1.10%)
43.60% (5.65%)
25th Percentile
5.87% (0.61%)
38.53% (4.80%)
Median
4.74% (0.50%)
33.15% (4.00%)
75th Percentile
3.76% (0.38%)
19.88% (2.20%)
Best Case
1.16% (0.11%)
8.23% (0.85%)
Source: Moody’s, Brett Gallagher

* Users familiar with Moody’s data may note that my model default assumptions, when converted to annual rates, are lower than the annual average default rates over the period.  As certain outsized years have the effect of distorting the overall calculation of “average” and, as we are looking at a 10-year horizon, I feel the cumulative data, converted to an annualized figure, is more relevant.

 Using a wide range of default and recovery assumptions, we are able to construct a narrow range of likely outcomes for nearly any fixed income segment we desire.  While the returns due to risk assets appear relatively attractive when compared with developed sovereign markets, the range of returns are far below historic experience and most investors assumed return assumptions.

US High Yield Debt – Current Yield 6.01%, Median 33.1% 10-year Cumulative Default

                                       
Annualized Default Rates
Recovery Rate
0.85% 2.20% 4.00% 4.80% 5.65%
20.0% 5.31% 4.43% 3.30% 2.83% 2.34%
25.0% 5.34% 4.50% 3.45% 3.00% 2.54%
30.0% 5.37% 4.58% 3.59% 3.18% 2.75%
35.0% 5.40% 4.66% 3.74% 3.35% 2.95%
40.0% 5.43% 4.73% 3.88% 3.52% 3.15%
45.0% 5.46% 4.81% 4.01% 3.68% 3.35%
50.0% 5.49% 4.89% 4.15% 3.85% 3.54%


European High Yield Debt – Current Yield 5.85%, Median 33.1% 10-year Cumulative Default
                                             
Annualized Default Rates
Recovery Rate
0.85% 2.20% 4.00% 4.80% 5.65%
20.0% 5.16% 4.27% 3.14% 2.67% 2.17%
25.0% 5.19% 4.35% 3.29% 2.84% 2.38%
30.0% 5.22% 4.43% 3.44% 3.02% 2.59%
35.0% 5.25% 4.50% 3.58% 3.19% 2.79%
40.0% 5.28% 4.58% 3.72% 3.36% 2.99%
45.0% 5.31% 4.66% 3.86% 3.53% 3.19%
50.0% 5.34% 4.73% 4.00% 3.69% 3.39%


US Investment Grade (BBB) – Current Yield 3.87%, Median 4.7% 10-year Cumulative Default
                                              
Annualized Default Rates
Recovery Rate
0.11% 0.38% 0.50% 0.61% 1.10%
20.0% 3.76% 3.57% 3.48% 3.40% 3.06%
25.0% 3.77% 3.58% 3.50% 3.43% 3.10%
30.0% 3.77% 3.60% 3.52% 3.45% 3.14%
35.0% 3.77% 3.61% 3.54% 3.47% 3.18%
40.0% 3.78% 3.62% 3.56% 3.50% 3.23%
45.0% 3.78% 3.64% 3.58% 3.52% 3.27%
50.0% 3.79% 3.65% 3.60% 3.54% 3.31%


EM Sovereign (USD Pay) – Current Yield 7.66%, Median 33.1% 10-year Cumulative Default
                                             
Annualized Default Rates
Recovery Rate
0.85% 2.20% 4.00% 4.80% 5.65%
20.0% 6.85% 6.00% 4.92% 4.46% 3.98%
25.0% 6.88% 6.07% 5.05% 4.62% 4.18%
30.0% 6.91% 6.14% 5.19% 4.78% 4.37%
35.0% 6.93% 6.21% 5.32% 4.94% 4.55%
40.0% 6.96% 6.29% 5.45% 5.10% 4.74%
45.0% 6.99% 6.36% 5.57% 5.25% 4.92%
50.0% 7.02% 6.43% 5.70% 5.40% 5.10%

In my next post, I turn to global equity markets.

Saturday, June 15, 2013

The Profitability Illusion

The current near-record level profit margins of the S&P 500 are largely an illusion, created solely by the fact that interest costs have fallen precipitously, even as overall debt levels have increased.  Operating profitability, is actually below average.  As the Fed’s Quantitative Easing program is unwound, earnings are at significant risk

Current profit margins for S&P 500 companies remain near historic highs even as the broader economy struggles and real income growth remains anemic.  The stock market trades near record levels supported, if not by fundamentals, by promises of the Fed to hold interest rates near historic lows.  Today though, the certainty of those promises is being discussed with potentially very negative consequences for US and Foreign Markets.

Market bulls point to high profitability and supportive market action as well as benign valuation as reason for their continued positive stance.  Indeed, market participants are by many measures, as bullish as ever (hedge fund net longs, investor sentiment measures).

However, analysts, like myself, who believe that margins tend to be cyclical in nature, caution that today’s high margins are a reason for restraint, not celebration.  Traditional valuation metrics like P/E ratios, tend to understate the valuation of markets when margins are well above average, as they are today, leaving open to question whether the factors supporting the market are capable of remaining in place for an extended period.

















Bulls will counter that we have witnessed a permanent shift upward in margins given the now global nature of production and the ability of corporations to manage costs better than ever by using offshore operations when beneficial.  This same argument is often cited when explaining why US personal income growth remains anemic.  While on the surface this is a believable narrative, the data does not back it up.

When margins are decomposed into their component parts:
  • ·         operational factors (sales less the direct costs of production)
  • ·         tax factors (the percentage of sales one forfeits in taxes) 
  • ·         financing factors (amounts paid due to corporate financing decisions), and
  • ·         extra-ordinary items (one-off items, not likely to be recurring in nature)
it becomes obvious that the historic profitability of the S&P 500 today relies solely on the fact that interest costs have fallen precipitously during the Fed’s period of QE even as overall debt levels have increased.

Current net margins are quite high by historical standards (8.04% versus the 15-year average 6.55%).  However, “operational margins” (the profitability of a company apart from their taxes and financing decisions) are now actually below average – so much for the benefits of global production.  The reason for the discrepancy between margins as generally discussed and operational factors has to do with the very low level of interest expense (1.78% of S&P 500 sales compared to an average of 3.88%), even though overall leverage (debt as % assets) has risen to 14.2% from the long-term average of 11.5% (Averages use year-end figures calculated from Dec 1998 through Dec 2012).

The charts which follow demonstrate this dynamic quite clearly.  After a bump during the period 2005 – 2007, interest expenses have fallen dramatically in spite of the fact that debt levels climbed (most precipitously in 2009).  To measure leverage, I have chosen to show both Total Debt to Asset as well as Net Debt to Asset measures.  It is my belief that net debt better hints at corporate vulnerability to leverage as it takes into account “tactical” debt issuance where retained cash can, theoretically, be used to immediately reduce leverage should borrowing costs reverse).




























The chart below shows “operational margin” levels since 1998.  Current readings are slightly below average.  Should interest costs rise and encroach on overall business profitability, it is net margins that will have to suffer disproportionately.


Sources for all exhibits: Brett Gallagher, Zack’s Investment Research


Two conclusions can be drawn from the above.  First, given the low level of interest rates, further progress in margin enhancement via lowering interest expense without paying down debt would seem limited and operational metrics must improve if current margins are to be sustained.

Secondly, should rates reverse their downward trend, interest costs could have the opposite effect on profitability as financing costs rise dramatically.  If interest expenses revert to their historic average, net margins would fall below 6% (all else equal, this results in a 25% earnings decline from today’s levels).

IN CONCLUSION, assuming continued sluggishness in economic (and, hence sales) growth, high levels of leverage and a bottoming of interest rates, maintaining margins above the norm is unlikely and reversion to mean becomes a more likely outcome than a secularly higher level of profitability.  In such an environment, earnings are vulnerable as are P/E multiples, meaning equities themselves are at risk. 

In the next two postings to this blog, I will provide long-term return assumptions for US, UK, Continental European and Japanese equities (under a range of margin and P/E assumptions) as well as a variety of government and corporate bond markets using a proven valuation methodology.  The results will have significant implications for plan sponsors and other investors.