A recent report from Citi, delved into this critical topic from a very macro perspective. Now, while equities are a smaller asset class than bonds, it does get a disproportionate amount of research and media comment, which highlights the importance of equities in the mind set of the general population. The link between bond yields and equities has been a core benchmark for the analysis of risk for the best part of 100 years. Critically, the role of Central Banks has increased over the past 5 decades to a point where today Central Bank intervention is at an all-time high and is having a commensurate impact on global equity valuations. There are many factors of course that impact equity valuations. Fundamentals such as earnings and of course balance sheets of individual companies are key drivers in valuations, but we cannot deny that the future of equity market prices will certainly be impacted by what the outlook for bond prices are.
The COVID-19 induced financial meltdown has resulted in the most rapid implementation of global Quantitative Easing (QE) in recent times. This program of QE is expected to continue according to Citi. In fact, they forecast some $6 trillion of global asset purchases in the next 12 months alone. This intervention had the desired result, stabilising markets and ensuring liquidity was there if needed. The impact on Treasuries was stark. Yields fell from 1.2% back to 0.6% and have since traded sideways. The sideways move in US yields is reflected across other developed markets with Bunds, Gilts and JGB’s all imitating a crab. Will this sideways action continue? Well yes, according to Citi. The COVID pandemic has induced enormous increases in government debts. By 2021, US debt as a proportion of GDP is expected to rise to 132% from 107% in 2019. In the UK it is expected to rise from 82% to 106%, in the Eurozone 86% to 101% and Japan 240% to 270%. This increased debt load is expected to be funded by an ever increasing amount of bond issuance which needs to be bought which explains somewhat why Central Banks could keep borrowing rates from rising to much in the near future.
So what does a lower for longer bond rate suggest for equities? The following chart is interesting in that it gives an insight to a decoupling argument proposed by some, of equities from bonds. In the chart below, the dark blue line is the S&P 500 while the grey line is the UST 10y yield (right hand scale). The last time the S&P was at its current level yields on US Treasuries were 100bp higher. Equity prices are suggesting a recovery is underway while bond investors are being much more cautious.
Source: Citi Research, Datastream
Citi disagrees with this hypothesis. They suggest that massive QE is the underlying cause of the equity market rally, whilst keeping a lid on bond yields. Hence, we have seen a V shape recovery in equities while bonds resemble an L shape. In addition, investors could also be treating equities as a proxy for an inflation hedge, much like Gold has been in the past. This argument holds affair degree of truth when one considers bond yield on an inflation adjusted basis. Why would investors settle for a negative 1% return for TIPS (Treasury Inflation Protected Securities) when the S&P is on a div yield of 1.5%. In the UK, Index linked Gilts yield -2.9% while the FTSE yields 3.6%. Even Japan has a 2.0% yield compared to their zero % yield in TIPS.
So where in the equities space do we put our funds if QE is going to continue for the next year or so, and real bond yields remain capped? Cyclicals do better than defensives in this environment according to Citi and IT stocks are the standout. If real yields continue to be under pressure, then IT and related stocks will continue to outperform. The following chart from Citi highlights the relative performance of Global IT stocks relative to the US 10yr Real yield.
Financial stocks have historically tracked nominal yields. If nominal yields get capped by quantitative easing measures, then expect financial stocks, especially the big banks to also have their returns capped as lower rates impact the Net Interest Margins of the sector.
The value/growth discussion in equities is also impacted by what the outlook for real bond yields is expected to be. Tech stocks dominate the growth sector, especially in the US and this tremendous rally is epitomised by stocks like Apple which took 30 years to get to a market cap of $1 trillion, and only 18 months to get to $2 trillion. The outperformance of growth stocks is understandable when you consider the value indices are heavily weighted to financials which underperform in times of falling nominal yields.
One regional trade that Citi suggests is interesting to watch is the performance of Emerging Market equities. The US equity markets outperformance versus the Rest of World equities is due to the high prevalence of Tech in its index. Emerging markets equities performance has more closely replicated that of cyclical stocks, although the impact of currency has also contributed as Emerging Markets tend to perform better when the US$ is weak as we are experiencing now.
So looking forward 12 months, if nominal yields remain lower for longer, then growth should still be favoured over value, with Tech being the star despite the big valuation differentials while financial stocks like the big banks should cause investors to be cautious. Should nominal yields rise, due to say a faster recovery in global economies and improved inflation outlook (i.e. rising) then a more traditional strategy like 2009 style would be more appropriate in which financials and European value stocks would be the place to be.
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.