Equities or fixed income – which to overweight now?
16 May 2018
When looking at whether to use equities or fixed income it’s all about timing asset allocation shifts, says Richard Larner, head of Research, Brooks Macdonald. He looks at the current market and the implications for these asset classes.
While the economic backdrop of positive, synchronised global growth and subdued inflation has continued in early 2018, there has been a notable pick-up in asset market volatility.
Global equities entering a correction in February after a record 15 consecutive months of gains. This was catalysed by a sell-off in US treasuries, with the benchmark ten-year treasury yield having now risen to a key ‘break-out’ level around 3%.
Should yields stabilise above this sentimental threshold, it may cause some investors to question whether the multi-decade fixed income bull market that has been underway since the early 1980s has ended (Figure 1).
Figure 1: The 10-year treasury yield, trend break or continuation?
Ten-year treasury yields are at a key juncture of around 3%. This is the pre-crisis low reached in 2003 and the level at which yields topped out in 2014. It also represents the level above which the falling ‘trend’ line from the late 1980’s would be broken, indicating a change of trend. Source: Thomson Reuters Datastream
Impact of inflation expectations
Increasing inflation expectations have been a key driver of the recent rise in treasury yields (Figure 2), with the sell-off appearing to have been triggered by stronger-than-expected US wage growth data released in early February.
However, the global shift from quantitative easing towards quantitative tightening has provided a broader headwind to asset markets, with investors now focusing on downside risks more quickly than when the ‘central bank put’ was effectively putting a floor on valuations in recent years.
What has changed is that the Fed has ended its quantitative easing programme (in October 2014) and begun reducing the size of its balance sheet (in October last year).
Meanwhile, the European Central Bank has started tapering its own asset programme and looks set to conclude it later this year, while the Bank of Japan has reduced the value of its monthly asset purchases as a result of technical factors involved in its goal of maintaining its policy stance.
Although these changes have been the result of improved economic fundamentals, they are reducing the liquidity inherent within global fixed income markets.
Figure 2: US interest rates increasing with inflation expectations
Inflation expectations have moved higher since the start of 2016 and the Fed has raised US interest rates in response. Source: Thomson Reuters Datastream
Government debt and sovereign bond yields
Governments are set to begin issuing more sovereign bonds to finance expansive fiscal policies.
In the US, the Committee for a Responsible Federal Budget estimates that the recent tax reforms will require financing equivalent to just over 20% of US GDP over the coming decade. Furthermore, the US government is expected to implement a large infrastructure stimulus plan, which will require additional spending.
In Europe, elections have shown that voters have become tired of austerity programmes, which is forcing incumbent governments to consider more expansive fiscal policies.
Meanwhile, the Japanese government continues to run a large deficit in support of its economy.
Together with the shift in central bank policy away from quantitative easing and towards quantitative tightening, increased sovereign bond supply will put upward technical pressure on yields.
In addition, the value of developed world government debt issuance is expected to exceed that of central bank government debt purchases in 2018 for the first time since the Global Financial Crisis.
While investors are concerned about a potential acceleration in inflation, it could also remain subdued.
Although some economic data suggests that inflationary pressures are building, wage inflation is edging up only slowly. Even the stronger-than-expected February data release that catalysed February’s equity-market correction was subsequently revised lower in March.
Given the reduction in labour force participation that has occurred over the past decade, there is some uncertainty over how much slack still remains in the labour force; the lack of wage growth indicates that there may be more than the current rate of unemployment indicates.
Meanwhile, the structural headwinds that have kept inflation subdued in recent years should persist in 2018; these include demographic changes, technological developments, high household debt levels and regulatory factors that are containing the rate of credit creation. In any case, wage growth remains a key variable that both the Fed and investors are watching for signs that further policy tightening is necessary.
Central bank policy going forward
Global growth remains positive and the US economic cycle is likely to be extended by the government’s recent fiscal measures. There also appears to be room for the economic expansions in Europe, Japan and the emerging markets to continue in the medium term.
As such, our base case is that global growth will remain positive in 2018, which will allow central banks, most pertinently the Fed, to continue to tighten their monetary policy stances.
Escalating protectionism or higher oil prices could drive inflation higher in the short term, causing policy to tighten more quickly than expected
Our base case is that inflation will remain contained and this should prevent treasuries selling off too quickly. However, there are various tail risks that could change this view.
The recent up-tick in protectionist political rhetoric has seen investors become concerned about trade wars. The implementation of trade tariffs or other measures could have significant inflationary and anti-growth consequences, with follow-on implications for global monetary policy.
However, the measures announced to date should have only limited impact and we are encouraged that the US and China, as major protagonists, appear keen to avoid action that would cause significant economic damage.
Slowing of global growth?
Despite the current positive trajectory of global growth, there is a risk that it will slow. Some of the world’s major economies, including the US, are progressing further through their economic cycles and will begin to experience cyclical slowdowns at some point.
We note that demographic changes over the past decade, such as a reduction in labour force participation, have added uncertainty as to how much spare capacity remains within the US economy.
Meanwhile, China’s economy could slow more quickly than expected as its government seeks to reign in the rate of credit creation. As was the case in early 2016, this could raise concerns over the sustainability of the global economic expansion, causing risk sentiment to deteriorate meaningfully. We will be watching closely for signs that such trends may be developing.
Risks of holding treasuries
There will always be a level at which investors will judge themselves adequately compensated for bearing the risk associated with holding treasuries.
We recently upgraded our view on international sovereign bonds (from negative to neutral) on valuation grounds, with yields having increased significantly over the past year (albeit currency-hedging costs remain prohibitive for most sterling-denominated investors).
However, we expect strengthening growth and the trend towards less accommodative policy, particularly in the US, to continue to act as headwinds against fixed income markets in the coming year.
If growth were to remain strong and force interest rates higher, we could become more pessimistic on the sector in the future.
However, if growth and inflation were to decelerate, this could lead us to become more optimistic towards developed world sovereign bonds, given their status as safe haven assets.
We note that it was inevitable that the ten-year treasury yield approached the key 3% psychological level as the Fed raised rates, but what is important is whether it stabilises around this level as it did in 2014 or whether we see further immediate selling.
Headwinds facing fixed income markets
Investors have become more wary of the risk that higher treasury yields pose to equity markets, given the ten-year treasury yield’s role in asset valuation calculations and the likely effect of a move significantly above the key 3% psychological level on investment sentiment. However, equity earnings yields are still far higher than those of their equivalent corporate bonds (Figure 3), which is providing a floor for valuations.
Equities should also benefit from robust earnings growth and technical support provided by share buyback activity, which have both been boosted by the recent US tax reforms and changes to the rules surrounding the repatriation of corporate capital held overseas (Figure 4).
Overall we are marginally overweight equities as we continue to favour the asset class relative to fixed income, but we will look to shift our exposure within equity markets as higher yields have various implications for sectoral, geographic, quality and stylistic allocation decisions.
Figure 3: US equity earnings yields exceed corporate bond yields
Equities’ earnings yields remain superior to the equivalent corporate bond yields, suggesting the former still present value in relative terms. Source: Thomson Reuters Datastream
Figure 4: Global equity valuations have improved
The recent US tax reforms have boosted corporate earnings, thereby making equity valuations more attractive. This has been one of the key factors supporting our ongoing preference for equities over fixed income, with the latter having also become more attractively valued as yields have risen. Source: Thomson Reuters Datastream
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