Risk premiums for the age
Risk aversion and age are supposed to be positively correlated. As such, I should be taking fewer risks given retirement is becoming a less distant prospect after just having celebrated a psychologically important birthday. Capital preservation is an easier choice today given the rise in bond yields and the prospect of higher compound returns. It strikes me that given the current backdrop i.e., war, a soft growth outlook and tighter monetary policy, equity risk is underpriced, and rate risk is overpriced. An interesting consideration as 2024 investment decisions loom.
I turned 60 last weekend (I know, I do not look it - moisturiser has been key). If my parents had been able to invest in a vehicle tracking the FTSE All-Share Index back in November 1963 – as a gift for their newborn – the total return would have been 8,907%, an annualised compounded return of 7.8%. Unfortunately, they did not. But as I was using the Bloomberg terminal to calculate what my fortune could have been, it struck me that 7% to 8% is a standard expectation for long-term equity returns. Over the same period, the MSCI World Index has delivered an annualised 7.43% while the Dow Jones Industrial Average has achieved 7.85%. Looking forward, should such returns be reasonably expected for the next few years? Perhaps, but there are doubts around the outlook for the next 12 months.
The first doubt is around the macroeconomic outlook; and we are heading into the season of the annual outlook. I expect most will suggest sluggish growth, further declines in inflation but only modest cuts to interest rates. Downside risks will be given more weight than the prospect of a growth reacceleration. Nominal GDP will be much lower than it has been since 2021. Corporate profits are a geared play on nominal growth and the recent relationship between nominal GDP and S&P 500 earnings per share (EPS) suggests it will be tough to reach the 10% annual growth forecast for EPS next year. I believe the outlook is better for bonds.
Where is the risk premium?
The second doubt is around risk premiums. Equity multiples have risen in the US and Japan, although they are marginally lower in Europe than at the end of 2022 (based on forward-looking earnings expectations). This reflects decent equity returns in 2023, at least in the US, Europe and Japan. Given the rise in bond yields, the crude equity risk premium has fallen to multi-year lows. Indeed, in the US, the dividend yield on the S&P 500 is well below the real yield on inflation-protected Treasury securities. The US is the extreme and the gap between equity and bond yields has not fallen as much in other markets. But the US market usually sets the tone. Bonds have become cheaper this year. The term premium has gone up in the rates curve because of the uncertainty over the appropriate future neutral interest rate and the path of fiscal policy and government borrowing.
What about credit? There is a positive correlation between equity returns and credit spread developments. Mirroring the situation in the equity markets, US credit is more expensive (spreads are narrower) than European credit (although all in, yields are more attractive). Investment grade and high yield spreads in the US sit at around the 50th percentile of their distribution since 2013. On that metric, European and UK credit spreads are better value. US high yield was looking cheaper, but spreads have narrowed recently. But the devil is in the detail as companies that have publicly reported disappointing earnings are getting punished in the bond market. In conclusion, credit is attractive given the long-term compound yields on offer, but spreads could respond by moving wider on any equity sell-off.
To recap, the consensus is for growth to be softer, inflation to be lower and the debate over the timing of interest rate cuts to intensify. The risk premium has moved in favour of bonds. Any decision on where to invest at the start of 2024 needs to consider what an old fund management colleague of mine used to call the eighth Wonder of the World – compound interest. Investing 100 units of currency in a five-year maturity bond when the prevailing yield was just 1% would have only grown to be worth 105.1. Doing the same today with the yield at 4.5% in the US, the investment would be worth 124.62 after five years with all the coupons re-invested. That is 4% more in annualised compound returns. Quantitative easing made bonds so unattractive that investment capital went into equities or credit (where spreads gave a bit more return). That game is over.
Pay for growth?
There are doubts about the prospects of equity outperformance but that does not necessarily mean equities will not deliver. Mean reversion – where valuations and performance return to their long-term average - could kick in given the US market has outperformed bonds by around 13% since early 2020, compared to a historical beat of around 5%. Assessing the outlook for technology growth stocks makes the traditional asset allocation decision more complicated. Are the future growth benefits of artificial intelligence compelling enough to buy stocks today that are trading on very high multiples? The S&P 500 Information Technology (IT) index is currently trading with a price-to-earnings ratio of 28 times (more than 5% lower in terms of earnings yield compared to the current yield on high yield bonds). However, valuation has rarely stopped them. These are companies with strong balance sheets, little debt, a lot of cash, and producing goods and services that enterprises and consumers want. The barbell of short-duration fixed income and technology stocks has done well this year – the short-duration US high yield and S&P 500 IT indices are up 5.2% and 45% year to date as of 8 November, according to Bloomberg. If rates are staying high and the US economy avoids a recession, why not do it again?
The macro outlook is key though, as the view on credit and high yield critically depends on whether more serious credit issues start to emerge. We might not have seen the full impact of monetary tightening yet. The Federal Reserve’s (Fed) Senior Loan Officer Opinion Survey for October suggested US banks are still, on balance, tightening lending conditions. Money supply growth is negative even if the money stock (representing macro liquidity) is still above the trend level it would have been at if there had not been the pandemic and subsequent monetary response. Economic data is softer, even though activity remains resilient and stock market commentators continue to be bullish. It was striking when I met with my equity portfolio management colleagues last week how many of them reflected that their companies - while having reported decent third quarter (Q3) earnings, were steering guidance lower for Q4.
Look for value opportunities, which 5% is
For now the soft landing is still on track. October’s inflation data will be released next week. The Bloomberg consensus is for the core Consumer Price Index to come in at an annual rate of 4.1%, unchanged from September and still too high for the Fed. So do not expect any change in the messaging from Washington. Comments from Fed officials over the past week were very much reinforcing the “higher for longer” line. That may limit the extent to which bond yields can fall in the short term and, indeed, another test of the 5% yield on 10-year Treasuries cannot be ruled out. Disappointing inflation data, robust growth data or hawkish Fed speak would do it. Looking at the charts of how Treasuries have traded, there were initial rejections of a 3% yield and a 4% yield, but eventually yields moved higher. I do believe, should that happen, it could be seen as another buying opportunity as we saw in mid-October. Compound returns rise exponentially with higher spot yields, raising the likelihood of higher real returns for fixed income investors.
(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 9 November 2023, unless otherwise stated). Past performance should not be seen as a guide to future returns.