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.
UK market
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.
Key points
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.
Bond yields
At this point we have to concede that, while the UK base rate is expected to remain at its current low level until well into next year, UK bond yields are expected to rise in the months ahead.
In my view, this is likely to be a reflection of a general rise in bond yields in the developed world – notably the US – and the increase is likely to be moderate.
This does not make equities a one-way bet, however. In addition to record low interest rates, another driver of asset markets has been central bank quantitative easing (QE), where, primarily, bonds are purchased by the central bank and, via a process of asset substitution, much of the money flows into so-called risk assets, with equities the key beneficiary.
Given that the Bank of England recently finished its most recent QE programme, it could be argued that equities are now vulnerable to a correction, particularly in the light of recent more mixed UK activity data.
However, I feel the weight of evidence points the other way. UK equities exist within the global capital markets and whatever one feels about the domestic outlook, on a dividend-yield basis, they look attractive to their international peers.
Elsewhere, while the prop of QE might have been taken away, I think the pickup in corporate profits offsets this.
Finally, and this is perhaps the most important point, the revenue of large and medium-sized listed UK equities comes predominantly from overseas, which has been boosted by the weaker pound. To sum up: equities remain the preferred investment choice.
Jon Cunliffe is chief investment officer of Charles Stanley
