Should investors be overweight bonds or equities?

Bonds

Fredrik Nerbrand

Global head of asset allocation, HSBC

Bonds have enjoyed a 30 year bull run, leaving yields close to historic lows. So there is plenty of talk that now is the right time to shift into equities.

We think this would be wrong for two reasons. First, recent economic data suggest short-term cyclical weakness. Second, longer-term structural headwinds, such as ageing populations, will act as a drag on growth. Equity bull markets tend to transpire when five factors align: low equity valuations, falling real bond yields, improving profitability, improving demographics and a reduced regulatory burden. Looking at equity markets today, few match all five.

US 10-year Treasury yields have fallen a long way since they peaked at the end of 1981. The current yield of around 2.4 per cent is well below the historic average. In Germany the 10-year yield is hovering just above 1 per cent, while the two-year is in negative territory. So why own bonds at these levels? Mainly because growth and inflation are weak by historical standards. In addition, although the Fed will soon stop buying assets through quantitative easing, the ECB may start a similar programme, which should support eurozone bonds.

Since the start of the Great Recession, growth numbers have disappointed. Our proprietary leading indicators of economic growth currently point to another period of weakness.

Although the US ISM manufacturing survey, a bellwether indicator of economic growth, posted 57.1 in July – comfortably above the 50 expansion/contraction line – we would urge caution. Since the 1950s, the ISM has only continued to improve 17 per cent of the time after reaching current levels. This suggests the latest reading need not point to the robust economic growth that equity bulls anticipate. If this is indeed the peak, company profits are likely to suffer and investors’ appetite for risk will wane.

Such a slowdown would pose a challenge for monetary policy: indeed, any attempt to ‘normalise’ interest rates with cyclical weakness on the horizon would risk policy error. This could easily perpetuate economic weakness and increase market volatility.

Talk of perennially low growth rates, dubbed ‘secular stagnation’, is worrying investors. One key reason why today’s ‘new normal’ growth rate is below that of the past is demographics. Traditional theory states that economic growth is a function of population and productivity. Productivity gains tend to be highest during the early years of work and then decline towards retirement. All else being equal, a population with many young people entering the labour force and few retirees should have strong productivity growth.

One way to quantify this is using the ‘Grad-to-Granny’ ratio – the ratio of 20 to 29 year olds to the number aged 55 to 75. The higher the ratio, the stronger future growth should be. Looking across the developed world, a worrying economic picture emerges. In Japan, where demographic trends have had a clear negative impact on growth, the ratio was 1.0 in 1980; today it is only 0.5. So, twice as many people are retiring as are beginning to work. In Europe, this ratio is expected to drop from 0.6 to 0.4 over the next decade.

This lack of productivity will have a big impact on economic growth and asset prices. The effects can already be seen, with corporates choosing to buy back shares and acquire other companies rather than invest in infrastructure to expand their business. Their view that they cannot find profitable investments is consistent with the weak structural backdrop to the global economy.

A final point: a large proportion of wealth is owned by the baby boomers. As they grow older, their demand for safety grows. We expect them to invest more into bonds in the coming years.

We do not think now is the right time to be overly exposed to equities. We are fond of bonds, as our current asset allocation makes clear.   

Equities

Mike O’Sullivan

CIO UK and EEMEA, Credit Suisse

Michael O'Sullivan, Credit Suisse

Equities and bonds have performed well so far this year with Treasury yields below 2.5 per cent and the S&P index just off recent highs at the time of writing. It feels somewhat like the 1990s Goldilocks world in which the mixture of growth and inflation was neither too hot nor too cold. There appears to be something of  a global economic recovery – Chinese indicators are stabilising, the Anglo-Saxon economies have moved to a qualitatively higher level of growth momentum and most indicators point to an ongoing recovery in Europe.

In an orthodox business cycle recovery, bonds tend to underperform equities and many investors would have expected Treasury yields to be closer to 3 per cent given the pick up in growth in the US.

Our investment strategy is overweight equities and underweight government bonds and by Christmas we would expect the performance differential between equities and bonds to have widened. Our sense is that the well-bid bond market is partly anticipating the end of quantitative easing by the Federal Reserve by October, partly pointing towards lower than long-term average trend growth rates globally and partly reflecting an investment climate where even moderately attractive yields draw in buyers.

However, as growth builds in the US and broadens globally, we suspect that by the year-end more and more investors will discuss the prospect of a return to normal levels of inflation, and others might well begin to worry that central banks, notably the Federal Reserve, are ‘getting behind the curve’.

In this respect, the Bank of England is a very good lead indicator for other central banks in that it demonstrates how monetary policy may need to be reset in the context of a pickup in the pace of growth and we have already seen some tentative signs of volatility in the shorter end of the US bond curve.

Another enigma closely associated with monetary policy is the very low level of volatility. Geopolitics in particular has not had a major impact on markets and this may be due to the fact that the central banks themselves are geopolitical players. The effect of liquidity provision in different forms by the Federal Reserve, Bank of Japan, Bank of England and the ECB  has driven returns across asset classes and has heavily conditioned investor behaviour.

One school of thought argues that in the midst of investor complacency, volatility will soon return to long-term average levels. While volatility is probably too low from a long-term historical point of view, our analysis shows volatility tends to be ‘regime’ driven in that it operates in phases of either high or low levels.

Low volatility phases or regimes tend to occur in the context of a macro recovery, low macro volatility and easy monetary policy. Historically volatility has only tended to be high when the Federal Reserve is raising interest rates.

With the Fed now set to finish its ‘taper’ by October, it seems Janet Yellen at least is prepared to take a less pre-emptive stance on upside growth and inflation risks. This, and the potential for the ECB and BoJ to introduce further monetary stimulus later this year make us consider that volatility compression can continue through to 2015, so that spikes in volatility represent buying opportunities rather than ‘exit’ signals.

The notion of volatility compression puts a greater onus on ‘alpha’ and ‘corporate cash’ as sources of returns within equities and as such our thematic focus is on sectors such as technology, healthcare, small caps in Europe and on merger and acquisitions as a catalyst.