Higher bond returns and the 60/40 portfolio
Yields have gone up on bonds relative to the yield on equities. The gap, in some cases, is back to levels not seen for more than 20 years. To me that suggests that total returns from bonds are more likely to be positive going forward, ending the three-year run of losses, and that returns from typical balanced portfolios can also potentially improve. The outlook is clouded but the effect of compounding higher yields in the fixed income market should not be overlooked.
Around the millennium, the yield on US Treasury 10-year maturity bonds fell below the earnings yield on the US equity market. The earnings yield is the inverse of the price-to-earnings ratio, and it is the yield investors would get if all earnings were paid to shareholders. A percentage of earnings is distributed to shareholders in the form of dividends. The rest is either retained for growth or other reasons or returned to shareholders periodically in the form of share buy-backs. Nevertheless, the ‘earnings yield gap’, as it is known, is a well-used benchmark for looking at the relative value of bonds versus equities. Just recently, 10-year Treasury yields have risen above the earnings yield on the US equity market. For some observers, this suggests a substantial change in the relative attractiveness of bonds versus stocks.
Using the dividend yield itself as the comparator to bond yields, in most major markets the dividend yield rose above bond yields following the global financial crisis – quantitative easing (QE) suppressed bond yields relative to stocks. However, over the last two years, dividend yields have fallen sharply relative to bond yields. In the US and European markets, the composite trailing dividend yield is now below benchmark government bond yields. Investors are almost certain to get their coupon payments from governments but they can’t always be certain of receiving dividend payments from the companies they invest in.
If a direct or indirect target of quantitative easing was to make equity markets more attractive to investors, then it worked. Now, however, the opposite is becoming true. Bond yields are rising relative to the yield on equities. Looking at the US S&P 500, the market cap-weighted index’s earnings yield is now slightly below the 10-year Treasury yield, while the equally-weighted index’s earnings yield is less than 1% above the 10-year Treasury yield. At the height of market concerns on the outbreak of COVID-19, the gap was 6% to 7% and for the 20 years before the pandemic the gap was in the 2% to 5% range.
Where to bet?
The dividend yield on US stocks is around 1.6%. The five-year Treasury yield is 4.9% and the yield on a typical corporate bond index is close to 6.5%. Average dividend growth needs to be at least 3.3% per year for stocks to compete with bonds - more if investors require a premium for the inherent higher volatility of equities. Of course, equity prices could rise on optimism about the economic outlook, but this is not guaranteed. The current consensus expectation is the S&P 500’s earnings growth will be around 10% over the next year. If that is correct, then equities look fine. But with the macro outlook remaining very clouded, there is surely a case for a more conservative asset allocation position.
Shifting risk premiums
The UK market dividend yield has also fallen below the government benchmark bond yield for the first time since 2010. In Europe and Japan, the dividend gap is still slightly positive although it has come down as bond yields have risen. There is an argument that bond risk premiums have been rising because of uncertainty over the appropriate level of future interest rates that is consistent with meeting central bank inflation targets. At the same time, relative equity risk premiums appear to have fallen. Keep in mind that realised historical volatility of returns from equities is around three times that of government bond returns.
It may be too simplistic to say that equities have become unattractively expensive relative to bonds. The last three years of negative bond returns do not make that argument an easy one to make. However, there has been a shift in expected risk-adjusted returns because bond yields have risen so much. There are two points to consider here. The first is that current bond yield levels suggest a high probability of investors receiving positive returns. Using US bond yield and index data going back to 1973, analysis suggests that investing in an index at today’s yield of 4.9% on 10-year Treasuries would theoretically provide a return over one year of close to 10% and over two years of 17%. Of course, past performance is no guarantee of future returns, but today’s yield, historically, has represented an entry point at which subsequent returns are always positive given a minimum holding period of one year.
The second point is that the outlook for fixed income returns today changes the way investors might view a typical balanced portfolio of equities and bonds. Before the QE period, bonds delivered positive returns most of the time (periods of negative returns were short-lived and not that material, unlike the unprecedented run of bond losses since 2021). They also tended to deliver positive returns when returns from stocks were negative – like during recessions. In stable economic regimes, both bonds and equities delivered positive returns with yields high enough to generate income and stocks benefitting from positive economic growth. Before the global financial crisis, it would not be unusual to expect returns from a typical 60% equity and 40% bond portfolio to be in the region of 10% annualised. In the last five years, the rolling return from a stylised 60/40 portfolio is between 0% and 6% depending on whether it was invested in the euro, sterling, or US dollar markets. In all cases, recent returns from those balanced portfolios have been lower than was the case when bond yields were last back at current levels.
Do not forget the bad things
I am not sure we are at a turning point in investment markets. Huge headwinds remain for investor sentiment. Official policy rates are high and there is little relief in terms of rate cuts priced in before at least the middle of next year. Cash remains a serious competing asset class. But there is reinvestment risk through holding cash which will become very evident once central banks start to cut rates. Other risks are obvious – potential recessionary trends in the major economies impacting on corporate earnings and credit quality, the risk of escalation of the conflict in the Middle East, the ongoing war in Ukraine and political uncertainty around the US-China relationship, especially as Donald Trump remains in the US Presidential election race.
Risk-off concerns are building
However, the abrupt shift in relative risk premiums has increased the attractiveness of fixed income relative to equities. Bonds should potentially deliver positive returns over investment horizons that appeal to most investors (one-to-three years). Returns may remain volatile. Central bank policy is uncertain when current inflation rates are a long way above the anchor of the 2% target rate, which could induce a period of fears of rates having to go even higher. However, for what it is worth, there is starting to be more sell-side commentary about increasing credit problems in the US, weak consumer spending in the UK and the general malaise in the Eurozone economy. A US government shutdown remains possible next month which would impact on GDP growth and our ability to assess how the economy is performing (as the government would not release economic statistics during a shutdown). All of this shifts the balance towards a more risk-off tone in markets.
Inflation is key – will it be done in 2024?
The biggest threat is inflation. The consensus is that inflation falls further in 2024. The problem is we do not know how inflation dynamics have changed or what the structural shocks to the global economy in recent years have done to pricing behaviour. Public sector workers in the UK have received large pay increases this year – might that be built into wage expectations going forward? Companies have surfed on the general inflation theme to leverage their own (higher) pricing policies. Commodity markets are sensitive to disruption and climate change. Hopefully, two decades of low inflation will have a legacy impact on inflationary behaviour and we avoid another inflationary wave. In that case, nominal and real returns can make 60/40 investing worthwhile.
(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 20 October 2023). Past performance should not be seen as a guide to future returns.