What Could Impact Stocks and Bonds in 2018
While yields on bonds remain low, equities offer attractive risk premiums. But where are equities and bonds headed this year? Is an end to the bull market in sight?
“Are there more buyers than sellers?” This is the primary question behind every tactical investment decision. Fundamental questions regarding valuations, profit growth or inflation are ultimately of secondary importance, since our assessment counts for less than that of the market as a whole.
After all, the market always has the last word. Our evaluation is of little consequence if the overall market does not share it.
There Are More Bond Than Equity Purchases
For example, since the 2009 financial crisis, a total of USD 1.8 trillion has been invested worldwide in global bonds, but only USD 612 billion in global equities (source: Credit Suisse, EPFR). Even over the last six months, there were one and a half times more bond purchases than share purchases (USD 185 billion in bonds versus USD 127 billion in shares).
Similarly, surveys show that pension fund equity allocations are still, on average, near their historical lows for the last 50 years. In the USA, the current equity allocation for pension funds averages around 30% – historically, this figure has been much higher. From 1960 to 2008, it averaged 50% in the USA and 41% in Switzerland. In the UK, the allocation has fallen from 70% to 40%, and in Germany from 40% to 11% (source: Credit Suisse).
So much for a stock market bubble.
is currently the equity component of pension funds in the US.
Equities Have Further Upward Potential
Many investors are surprised that despite a decent performance in 2017, the logical assumption that equities would be more expensive today than they were a year ago is not, in fact, the case. Rather, a good portion (about 75%) of last year’s stock market performance was owing to strong earnings growth – and not, say, higher valuations.
In many markets and sectors, thanks to this strong earnings growth, price/earnings ratios (P/Es) are actually at the same level they were 12 months ago. Moreover, companies’ current earnings revisions suggest that, all else being equal, global equities have some 20% upside potential (source: Credit Suisse).
Equities Are Valued from "Fair" to "Cheap"
Relative to bonds (and this is more relevant than a historical viewpoint), share valuations appear to be, on a global average, and naturally with differences among the sectors and regions, still between “fair” and “cheap.”
IBES indicates that global equity risk premiums are around 5.6%, while our strategists believe a risk premium of 3.5% is appropriate. This implies considerable upside potential, particularly in the case that equity risk premiums fall below their fair value, say between 2% and 3%, on positive market sentiment.
Bonds Are Favored by the Market
Two comparisons illustrate the market’s ongoing preference for fixed-income investments: ten-year bonds issued by Nestlé are trading at a yield to maturity of 0.2% p.a., which implies a bond P/E of 500x. Nestlé shares, on the other hand, are trading at a P/E of just 21x and offer a dividend yield of 3.1%.
The enormous difference in valuation between these two securities from the same firm illustrates the equally serious investment bind facing yield-seeking institutional investors.
Equities Are Appreciating Only Slowly
In Europe, the yield on high-yield bonds has already fallen to a level near the average dividend yields for European shares. If we consider that bonds are redeemed at a maximum of 100%, and that the average quality of the overall stock market is probably better than that of the poorly financed high-yield issuers, it becomes clear that the institutional investors “forced” to buy yield, such as pension funds and insurance companies, create opportunities for equity investors.
In the current environment of low interest rates and a demographic shift towards aging beneficiaries, pension funds and insurance companies are still compelled to purchase high-yield paper (e.g. bonds and real estate). In the process, they widen the relative valuation gap between increasingly expensive bonds and shares that are rising more slowly in price – in favor of shares.
One cannot simply conclude from the longevity of the current bull market that a correction is now imminent.
Burkhard Varnholt, Credit Suisse
Moderate Inflation Helps Equities
It seems likely that a moderate rise in inflation could trigger a shift from bonds into stocks (which would have gained in relative appeal). From a historical perspective, only an inflation rate above 3% is detrimental to both bonds and stocks. And this is far from the case at present: we forecast a global inflation rate of 2.3% for 2018, and just 1.9% in the mature economies.
Finally, one cannot simply conclude from the longevity of the current bull market that a correction is now imminent. This statement sometimes surprises investors, since it contradicts an established conviction that the financial markets experience ups and downs with a certain regularity. In fact, however, the laws of probability still apply, such as the one dictating that even after ten coin tosses have come up “heads,” the probability of “heads or tails” on the eleventh toss is still 50/50. In other words, the past does not influence the future.
Further Good Years for Equities Could Follow
By the way, a recent study by Harvard University found that from a historical standpoint, a good year for stocks is often followed by further positive years. This “persistence effect,” which the authors glean from over a century of data, is ascribed to the effects of group psychology on a theory of the origin of bubbles, which usually create three or four good years before major distortions occur.
From this viewpoint, last year’s stock rally still has one or two good years ahead, with gains of more than +50% possible. Naturally, such a comparison is risky, but the authors have a very good reputation.