(Bloomberg) – Sometimes, when volatility rocks financial markets, the safest trades can quickly turn into dangerous bets.
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That’s exactly what’s happening in some corners now, as investors, spooked by the banking crisis and central bank uncertainty, rush into big tech stocks and highly rated corporate bonds. The rush to defensive assets has made both so expensive by historical standards that they could be vulnerable to painful reversals.
Legal & General Investment Management and RBC Wealth Management are among funds that have pulled back from a rapid rally in technology stocks. Goldman Sachs Group Inc., meanwhile, has identified a cheaper and safer strategy for low-volatility stocks.
“The danger now is to go full defensive and buy overpriced assets,” Frederique Carrier, head of investment strategy at RBC Wealth Management, said in an interview. “Defensive sectors have gotten a bit expensive and that’s why we’re not 100% up to quality.”
Across the spectrum of recession prospects, from those expecting a soft landing to those preparing for a hard one, money managers have gravitated to quality to protect themselves from the economic fallout from the collapse of three US banks and the government-sponsored bailout to protect a fourth in Europe.
The quality-heavy top 20 largest stocks in the S&P 500 have fueled the stock rally since the beginning of the year, with the index currently trading at a price-to-sales multiple above the peak of the dot-com bubble. Similarly, quality defensive stocks in Europe are trading at a premium of about 60% to the Stoxx Europe 600.
Patrick Armstrong, Chief Investment Officer at Plurimi Wealth, has just sold his position in luxury giant LVMH as he believes there is too much of a safety premium being priced into certain quality stocks. He continues to hold Apple Inc. and Alphabet Inc., but sees the risk of a “dead money” period when performance takes a long time to catch up with trading multiples.
The story goes on
“If you feel confident owning it, it’s probably too expensive,” Armstrong said on Bloomberg TV, “a mid-level reversal trade is very likely.”
According to Bank of America Corp.’s latest fund manager survey. Long positions in big tech stocks are the busiest right now, and investors hold the most bullish positioning in investment grade versus high yield on record.
This reflects investor confidence that large tech companies with rock-solid balance sheets and strong free cash flow will weather a recession better than many companies burdened with heavy debt burdens. Minutes from the Federal Reserve’s last meeting showed policymakers trimming back rate hike expectations after a series of bank failures rocked markets and bolstered forecasts of a “mild recession” beginning later this year.
At the same time, the potential for central banks to moderate aggressive rate hikes and eventually move to looser monetary policy could fuel further gains. The link between the tech-heavy Nasdaq 100 index and duration, a measure of interest rate sensitivity, could mean double-digit gains with every rate cut.
Read more: Nasdaq on track to become most expensive vs. S&P 500: macro view
“It’s not necessarily expensive for the late-cycle position we’re in,” said Christian Mueller-Glissmann, head of asset allocation for portfolio strategy at Goldman Sachs Group Inc., confident that high-quality trades, although more expensive, can be expected in a slowing market growth environment will perform above average.
Still, he recommends investors invest in low-volatility stocks that are expected to remain resilient in troubled markets while sharing characteristics such as strong balance sheets and profitability with pricier, high-quality peers. The Nasdaq includes Procter & Gamble Co., Merck & Co. Inc., Roche Holding AG and Verizon Communications Inc. in its list of low volatility stocks.
The market has “forgotten low volatility as a style,” he said. “They lost after the 2018 Fed pivot, but they have a history of outperforming in bear markets.”
Goldman also warns investors not to hold long credit positions, as the asset class often underperforms late in the cycle when default rates rise. Mueller-Glissmann stresses that while equity markets have a ‘survivorship bias’ given the dominance of quality defensive names, credit indices have not experienced the same compositional shift, with the risk of greater exposure to cyclicals.
Still, ETF inflows show that investors continue to flow into investment-grade credit funds, with inflows totaling $54 billion.
John Roe, money manager at Legal & General Investment Management, is positioning his portfolio for a downturn. He has his doubts about quality stocks with high valuations and how they will fare in volatile markets, preferring to play short credit names.
He has just ditched an overweight stance on technology stocks, turned neutral, and instead added AAA-rated European supranational credits, which offer a 60 basis point premium over government bonds.
“Tech’s outperformance in March was extreme,” Roe said. “Once investors know we are definitely going into a recession, regardless of how bad that recession might be, that would be enough for a re-rating.”
–With support from Ven Ram.
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