Risk / reward still favours equities

Brandon Snow's picture

A common theme when talking to clients is: Where can we find returns going forward? With historically low interest rates working their way through bond markets, yields from governments to high yield are unattractive.

We always say we don't mind taking on risk as long as we get paid for it, and with the low absolute level of rates these days, the expected reward often isn't worth the risk. The common consideration is that bonds offer stable returns, low risk and low volatility. However, when you look at absolute yield levels (especially considering taxes, fees and trading costs), the return isn't there to justify much risk at all. Also, considering the lack of transparency and illiquidity in the bond market, I would say that volatility in corporate bonds is understated. (A quick Bloomberg search found only 36 issues with yields above 5% that are actively priced in Canada!)

Over the last six years, the yield on the U.S. high-yield index (ticker: JNK) has been cut in half. Over the same period, the P/E multiple on the S&P 500 has been relatively stable, with the forward multiple now at 16x. In fact, the current return potential on U.S. stocks is second only to housing, as can be seen on this chart:

Source: RBC CM Quantitative Research

While we are always very pragmatic when investing, this chart suggests a potentially very bullish scenario: Where would equity valuations go if the extended valuation seen in bonds worked its way into the equity markets? Would we see a P/E of 20x?

We have seen bond managers begin making allocations into equities, and the multiples of defensive names have expanded (see chart below), but not the multiple of the market as a whole. Therefore, with the current macro backdrop in North America and the fact that the non-defensive names remain cheap, we continue to favour U.S. domestically focused cyclicals and growth (tech) names as offering the best risk-reward potential today.

Comments

Submitted by arpadCANADA on

What are your views in this context on the Canadian market, given that the portfolios you manage have a significant Canadian component? Are you still able to find value?

Brandon Snow's picture
Submitted by Brandon Snow on

There are always opportunities in any market, and lots in the Canadian market today. The two major sectors in Canada, commodities and financials are challenged right now, but there is still good value opportunities and great value creating companies to be found. Look at our top 10 holdings and you will see names like Couche Tard, Groupe CGI and Brookfield Asset Management. All these companies are world leaders, but considered Canadian, and trade at attractive multiples because I believe they are overlooked in Canada. Even domestically focused stories like Intact Financial, Dollarama and Weston/Loblaws offer compelling value. On the small-cap side there are even more opportunities. So no, we don't feel at all constrained by our ability to go only up to 49% foreign content in our Canadian funds.

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