U.S. equity markets recently reached new highs and riskier segments of the bond market are also thriving against an economic backdrop of moderate growth, low interest rates and low inflation. However, investors may be getting lulled into a false sense of security given the economic expansion and relatively muted volatility over recent years.
Investors have crowded into certain investments and may be overly complacent about the risk of a correction in some of the most popular segments of the market. For example, high-yield and emerging markets bonds have been appealing destinations for investors frustrated by the low yields available from government and investment-grade corporate bonds.
However, some holdings within high-yield and emerging markets debt may be vulnerable to economic turbulence or changes in sentiment. Dividend-oriented stocks such as utilities have also been popular as bond substitutes, but could lose ground if interest rates rise. “Platform” stocks such Facebook, Amazon, Netflix and Google (“FANGs”) that are providing rapid revenue and earnings growth have been the destination of choice for many investors who find themselves starved for portfolio growth.
Slowing growth, rising rates or simple changes in sentiment could create a correction in one or more of these market segments. Advisors should consider the risks and assess whether portfolio modifications are necessary to preserve the gains of recent years.
FANGs and other platform stocks may not grow indefinitely.
Platform companies such as the FANGs, Apple and Microsoft provide an “ecosystem” in which companies plug into the platform to add incremental value or gain access to a network of potential customers. The network effects from successful platforms create “winner take all” or “winner take most” economic models that are difficult to compete against.
However, platform stocks may not have uninterrupted momentum. Amazon and Netflix have sky-high valuations, with Amazon trading above 200 times estimated earnings for next year and Netflix at more than 100 time earnings. Any deceleration in Amazon’s growth trajectory would be a potential catalyst for the stock to fall, as doubts about the company’s ability to growth profitability enough to “justify” its valuation multiple. Netflix may also face challenges growing into its valuation, given that Disney is among the content providers expending considerable resources to challenge the Netflix platform. Antitrust considerations are a growing concern for Facebook and Google, as the European Commission scrutinizes both companies with a high degree of skepticism. Although Facebook, Amazon, Netflix and Google are great companies, it isn’t a given that they will each be great stocks to own in the future.
High-yield bonds offer a tempting yield premium over less-risky debt, but some investors may be getting carried away.
One of this year’s highest-profile debt offerings provides evidence that investors may be underestimating potential risks. In May, Netflix issued more than 1 billion euros of bonds with a 1-year maturity and coupon rate of 3.625%. Netflix is projected to have $2 billion of negative cash flow this year and faces considerable potential competition over the next 10 years. It’s logical to wonder whether Netflix bondholders are being appropriately compensated for their risk, yet the deal was three times oversubscribed.