Now is the time to “scale down risk” due to high valuations in equities and fixed income, according to a report by UBS.
“Stretched” valuations have made the recent momentum of equity indices such as the S&P 500 “difficult to justify”, the Swiss bank’s strategists said, adding that inflows into exchange-traded funds were “consistent with a ‘risk on’ trend”.
UBS highlighted the recent difficulties faced by Portuguese bank Banco Espírito Santo (BES) as a “canary in the coalmine” for equities.
The bank’s shares sold off dramatically after a rights issue in June and other Portuguese banks, sovereign bond prices, and even the VIX index were affected—something that UBS said “tells us a story about market positioning and market pricing”.
“The market is already pricing most of the potential good news and is prone to react to bad news,” the strategists argued.
“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries.”—US Federal Reserve.Turning to fixed income, UBS said spreads between European government bonds and US treasuries were too low, with some peripheral European countries’ bonds trading at yields consistent with a much higher credit rating.
“While European spreads were extremely cheap during the crisis, they now look too expensive,” the strategists said. “This tells us that it could be difficult for the market to absorb negative news—as we saw with BES.”
UBS’s concerns chime with the US Federal Reserve’s most recent Monetary Policy Report. It said equity valuations were “generally at levels not far above their historical averages” despite the S&P 500 and Dow Jones indices hitting all-time highs.
But the Fed added: “Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”
The central bank’s report also flagged the ultra-low reading from the VIX index, which indicates market volatility.
But not all market commentators are so negative.
A report from risk specialists Axioma covering the second quarter of this year found that some equity risk measures declined to levels not seen in more than 30 years.
Melissa Brown, senior director of applied research at Axioma, asserted that “risk is on holiday”, and claimed that an increase in risk levels was unlikely, “at least not in the near term”.
“Axioma’s statistical forecasts do not suggest there is something ‘bubbling under the surface’ that other risk models are not picking up,” Brown added.
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