The major equity indices worldwide have been reaching new highs as equity investors continue to climb the wall of worry. Certainly, the wall has felt quite steep of late, with valuations appearing stretched, central banks increasingly keen to wean the markets off cheap money and a variety of geopolitical concerns to consider. What should investors do?
There is always a tendency on the part of investors to worry about what might happen in the future at the expense of a thorough understanding of what is currently the case. Take the UK as an example.
The markets are right to factor into their thinking an assessment of the economic outlook in the light of post-election policy uncertainty and Brexit concerns. However, these should not blind us to the fact that we have had the best corporate earnings season in six years and the low level of bond yields still makes equities relatively attractive.
Elsewhere, if we see corporate earnings growth maintained at current levels, valuations are likely to become much less demanding as we head into 2018.
What is forgotten is that between 2014 and 2016 we had a combination of falling corporate profits combined with a generally positive equity market. This is a result of so called “earnings multiple expansion”, where the market is prepared to pay a higher multiple of future earnings. What was the cause of this? In essence it was a result of falling investment-grade bond yields.
If fixed-income investors were prepared to pay a substantially higher price for the same income stream, then equity investors were happy to follow. This influence was most keenly felt in the highly rated so-called growth stocks which, in a world of low bond yields, increasingly became viewed as alternatives to fixed income, the so called “bond proxies”.
Back in 2016
During the throes of the European Central Bank and Bank of England’s bond buying programmes of 2016, large swathes of global government and investment-grade bonds were yielding less than 0 per cent.
In a curious inversion of the usual order, investors were buying highly rated bonds for capital appreciation (central banks were ensuring their prices would rise) and equities for their relatively attractive income.
Markets have moved on since then, but this clearly demonstrates that bonds do matter. They matter because they provide the yardstick against which the prospective returns on other asset classes are measured.
The chart shows the dividend yield on the UK stock market versus the yield on 10-year UK government bonds. It shows, from an income perspective, the increasing attractiveness of equities, which is unlikely to be undermined even if we do see a reasonable rise in bond yields.
The major equity indices worldwide have been reaching new highs.
Between 2014 and 2016 we had a combination of falling corporate profits combined with a generally positive equity market.
UK bond yields are expected to rise in the months ahead.
The chart highlights the key factor driving asset preferences: we are in a world where there is a structural shortage of yield, and it will take a considerable amount of time and a degree of monetary policy normalisation for this to change.