Don't Break the Bond
20 December 2020
In the last week we have continued to see US equity market indices attain record highs. At the same time however we have seen valuations continue to rise to such an extent that some investors may argue they are now overvalued. The latest data from Bloomberg shows that, on a forward price to earnings measure, the S&P 500 is now at the same level it was in 1999. The same is also true when you look at price to sales. According to a recent report from Crescat Capital LLC, US equities are, across many other valuation metrics, trading in their 100th percentile, meaning they have rarely been as expensive.
Some of this can perhaps be understood. The approval of vaccines with high efficacy rates is certainly contributing to the current euphoria, as measured by research conducted by Haver Analytics, Pinnacle Data and Citi Research, that we see today. These high valuations are not going unnoticed however and now questions are being posed to Jerome Powell, chairman of the US Federal Reserve.
Rather than issuing a warning of ‘irrational exuberance’ like Alan Greenspan in 1996, Powell instead looked to defend current equity market valuations and encouraged investors to look at such on a relative rather than absolute basis. In particular, he was making reference to the valuation of equities compared to the risk free rate. At a press conference this week he said, “If you look at PE’s (price to earnings ratio) they’re historically high, but in a world where the risk-free rate is going to be low for a sustained period, the equity premium, which is really the reward you get for taking equity risk, would be what you’d look at,”
On this basis the chairman is indeed right. According to figures from Bloomberg, the actual earnings yield for the S&P 500 is near all-time of lows at circa 3.5%. At the same time however the yield on the US 10 year Treasury is only 0.95%, meaning that the difference between the two yields, or spread, is in the region of 2.5%. This is by no means near previous highs but is certainly more favourable than the period, for example, between the early 1980’s and early 2000’ when this spread was in negative territory.
This therefore begs the question however, just how reliant have returns from the equity market become on bond yield movements? There can be no question that bond yields have been driven lower by the very accommodative monetary policies enacted by the central bank. The latter have also made it clear that for now interest rates are going nowhere until we have seen a significant improvement in the US labour market and a sharp contraction in the output gap of the US economy. We should also not forget the change in inflation target recently adopted too, whereby they will now look to attain an average target of 2% inflation, a subtle difference in wording but meaningful all the same.
So what could put a spanner in the works? Well, one item being discussed more and more is the prospect for higher inflation and we would put this high up the list. Whilst the pandemic certainly brought about a deflation shock, the monetary and fiscal policies subsequently put in place have significantly increased the amount of liquidity available. Not only have we seen an increase in the monetary base, this time around we have also seen a substantial increase in broad money supply, something we didn’t see in the global financial crisis. The monetary transmission mechanism would typically see this flow initially into asset prices first and this appears to have been the case this time. As the wealth effect takes hold, this would then be expected to flow into economic activity and subsequently good and services prices.
Whilst central banks have indicated they would not likely respond to a pickup in inflation this does not mean that bond yield won’t react. Yes, yields at the short end of the yield curve are likely to remain anchored by interest rates being kept low. That does not mean however longer dated yields can’t rise. Unless we have seen a pickup in corporate earnings by then, the relative valuation of the S&P 500 will begin to look very different to the 10 year US Treasury yield and as that spread narrows so will the attractiveness of equities on this basis.
Rule 10-1 of portfolio construction in a multi-asset portfolio is diversification. Diversification has historically been achieved through carefully balancing allocations between equities and bonds. For much of the time this has worked, but over shorter periods the correlation between the two asset classes has been seen to increase. Are we potentially in danger of seeing such a further episode? Unless we see that increase in corporate earnings and if we are to continue to pay a greater focus to the relative valuation of equities I think the message is clear, don’t break the bond!
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