Autumn Investment Monitor 2017  

Equities coming to the fore as bond rally runs out of steam

Equities coming to the fore as bond rally runs out of steam
Global governments, including the UK, are gradually moving away from austerity

The global economic upswing has now lasted longer than a typical recovery – if there is such a thing. But it would be wrong to look for another recession around the corner. 

Crucially, the rate of economic growth has still been sub-par, meaning there could still be plenty of room for expansion. This is particularly apparent when looking at the progress of corporate profits. 

In most parts of the world – including in the UK and the eurozone – earnings remain some way below their previous peak. Even in the US, where the recovery has been more pronounced, earnings have only just about reached their long-term growth rate.

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In this environment it is normal to expect that the slow-yet-steady economic and earnings recovery will continue through the rest of this year, into 2018 and beyond. 

Another common trend of the recent past is running out of steam: namely, the outperformance of bonds over equities. Most investors have, in some shape or form, benefited as bonds have persistently delivered an equity-like return with significantly less risk, basking in the glow of undershooting inflation expectations and generous central bank stimulus. 

One of the consequences of this is that, on average, investors have forgotten how much risk needs to be taken to achieve the kind of returns traditionally associated with equities. Markets are about to remind them.

When looking at today’s pricing of bonds, it is apparent that much of the world offers a negative real yield. That is true not just for government debt, but also for investment-grade credit, where below-inflation yields are becoming increasingly common. 

Without further capital gains from falling yields or credit spreads, which are not expected, bond returns look set to be negative in real terms, and certainly a long way short of what investors have experienced over the past decade.

For many asset buyers – such as pension funds and insurance companies – there has been an increase in regulatory pressure to lower their risk profile, which could potentially put a floor under the bond market. So while bonds are expensive, the chances of picking them up cheaply in the foreseeable future look pretty low.

Equities, in contrast, offer the prospect of exposure to continued earnings growth as the breadth and depth of the global economic upswing develops. Furthermore, for investors looking for an income stream, global stocks offer a dividend yield at a respectable 2.5 per cent – nearly double the yield of global government bonds.

Yet the global economy does not work to a calendar, and while this expansion has undoubtedly been longer than most, it continues to be supported by central bank stimulus. In the first half of this year alone, the banks have printed approximately £2trn (£1.5trn) of fresh money. 

There are not many serious inflationary threats on the horizon that would motivate central banks to tighten monetary policy aggressively. Indeed, this summer has once again witnessed a period of falling inflation expectations and a corresponding lowering of forecast for interest rate rises.