Key TakeoutsIn May global bond yields have risen despite increasingly lacklustre economic data, which is not a constructive backdrop for global shares. There are few historic precedents where low bond yields and high equity valuations have occurred simultaneously, but the average bond yield for a US P/E ratio around 18 times earnings is 5.0%, so today’s yield of 2.2% suggest that US bonds are more expensive than equities.
Over the past 113 years, Australian shares have declined on 31 occasions, but bonds have declined in only five of those years. However, Australian investors could rightly question whether government bonds can diversify equity risk as the current low yield means not only lower future returns, but also increased price risk from a rise in yields.
Introduction - Diversification
Diversification is one of two techniques used by investors to reduce investment risk (the other being hedging) and it is a process of investing in securities or assets whose return outlook is imperfectly correlated with alternatives. The key criterion here is that asset prices behave differently in the same environment, yet this was not the case during the global financial crisis where credit, housing, equity and commodities all declined rapidly. More importantly, this may not be the case moving forward as nearly all asset classes have above-long-run valuations, which means lower future returns and more volatile markets.
Central Bank Policy
What has been clear in the 6-year economic and market recovery, more so than any other, has been the critical role of central banks in stabilising the economic outlook and facilitating rising investor sentiment in a lower-growth world. While central bank policy has been a ‘shock and awe’ tactic, it has sparked unintended consequences in that valuations have risen in every major asset class and there is little policy ammunition left for the next crisis.
Two key problems
The current 7-year US equity bull market appears quite mature. Indeed, while the US market is making fresh highs, it is only up +3% over the past six months and appears to be trading in a slightly-upward sloping trend, which could be knocked off its axis at any time by rising US interest rates. There are two problems for investors; firstly, a downturn in equity prices is likely to be driven by a downturn in bond prices (and a commensurate rise in yields) and secondly, there is little confidence that such a rise in yields will reflect an improving US macro picture. Conversely, the recent rise in bond yields reflected higher inflation as oil prices recovered and the US dollar depreciated.
The key message from lower rates
While central bank policy has been instrumental in lifting regional financial markets since 2008, there is little doubt that they have not addressed the key economic issues about potential growth in a highly leveraged world. In particular, lower than normal bond yields partially reflect central bank policy, but also worryingly soft economic growth and sustained low inflation, which are both inadequate to resolve the massive global debt burden.
Earnings growth versus cost of capital
Hopes that central bank policy can engineer above average growth in an over-leveraged world have failed in every major economy since 2008. But it has had a positive market effect as most of the global sharemarket rise since 2009 has been driven by valuation expansion in response to lower bond yields. Yet just as lower yields sparked higher share valuation, higher yields can have the opposite effect as occurred in the 1970s. While no-one is seriously forecasting a return to high inflation, the only way for equity markets to continue rallying during periods of rising bond yields, is for earnings growth to outweigh the rising cost of capital.
A worrying trend
A stronger US economy will be necessary to drive higher US earnings as corporates will struggle to push record margins even higher, particularly with a tightening labour market.
However, the current US recovery remains the weakest in history and growth appears to be sub-3% in 2015 given the subdued growth in the first half of the year. More importantly, the recovery in global oil prices and the decline in the US dollar are asserting upward pressure on US bond yields and the worrying trend in May was these higher yields occurred at a time where the economic outlook has been lacklustre. This is not a constructive development for the global and US sharemarkets. A bigger problem for investors is that there are few historic precedents where low bond yields and high equity valuations have occurred simultaneously. Indeed, the average bond yield for the current PE ratio of 18 times earnings, is 5.0%, but today’s bond yield less than half that level (2.2%) which suggest that bonds are more expensive than equities.
Some old rules aren't applicable now
If investors thought that if sharemarkets were overvalued and likely to underperform, then they would traditionally diversify this risk by investing in inversely correlated assets such as bonds. However, as in the US, Australian investors would question whether bonds can diversify equity risk as historically low yields means not only lower future returns, but also increased capital risk (see Chart 1). The top section of Chart 1 indicates that the lower the starting yield the lower historically has been the future three-year rate of return and the lower part of the chart shows that at a current yield of 2.9% the capital loss from a 1% rise in yield would be around -6.9%
CHART 1: LOW YIELDS MEAN LOW FUTURE RETURNS AND INCREASED CAPITAL RISK
Over the past 113 years, Australian shares have recorded a calendar year decline on 31 occasions, and bonds have recorded a negative total return in only five of these years. While Australian bonds have recorded an average +6.7% return in the 31 years, investors need to be aware of the tranquilising effect that average rates of return can have on investment thinking, as while bonds usually have good diversifying effect, in all five of negative bond years, yields rose and sometimes not by much (+0.6%).
Regardless of their sophistication, a fundamental decision for any investor is allocating between shares, bonds and cash around the world to meet their investment objective. While traditional ‘set and forget’ strategies, which invested in both equities and bonds, have served investors well for over 30 years, investors need to consider its’ effectiveness in the current investment climate. It is clear that with higher valuations, future returns are going to be lower in every asset class (see Chart 2), which means returns of a statically managed balanced portfolio will also be lower. In most regional sharemarkets, expected 5-year returns have declined by more than half between March 2009 and March 2015 and expected government bond returns are down by -40% and now below expected Australian inflation.
CHART 2: ‘SET AND FORGET’ STRATEGIES WON’T SAVE INVESTORS FROM LOWER RETURNS
Implications to investors
Asset bubbles need only three ingredients; a simple idea, plenty of liquidity and everyone on the same trade. The unprecedented move to cut interest rates to zero and in some cases to implement large scale QE programs had the desired short-term impact of stabilising the global financial system. However, those decisions have also had some unintended consequences with higher asset prices across the world based on relative yields, rather than absolute fundamentals. The clearest sign that maturing bull markets have evolved into bubbles is valuations and these are most prevalent in bonds. Meanwhile, equity valuations are stretched but unlike bonds are not yet at historic extremes and given that it has historically taken three rate hikes to burst asset bubbles, share prices could remain elevated for a while yet. Nevertheless, investors are eventually going to have to decide how to diversify valuation risk and in this world traditional diversification is likely to be less effective. Consequently, investors should cease focusing on the return of the index and start concentrating on the distribution of returns within the index, or put more simply, they need to focus less on benchmarks and more on opportunities. It is clear that equities have less valuation risks than bonds, and shares in Europe, Japan and some parts of Asia look superior to those of Australia and the US.