Rudi’s View: Bonds & Equities; Joined At The Hip

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In this week's Weekly Insights:

-Bonds & Equities; Joined At The Hip
-Conviction Calls & Best Ideas
-In Search Of Yield
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Bonds & Equities; Joined At The Hip

The most important financial indicator right now may not be the level of government bond yields, or the implications from weak leading economic indicators, not even the fact that forecasts for US corporate earnings for the two calendar years ahead seem more like pie in the sky.

The most important indicator, possibly, is one the average investor is rarely confronted with; the equity risk premium, or ERP.

This indicator is not often mentioned or reported on by mainstream media, let alone your average tip sheet or investment newsletter. But it has been front of mind for many professional asset managers and investors over the past 18 months or so. A much lower than usual ERP is also what has the more cautious professional concerned about what 2024 might have in store for equity markets and investment portfolios.

The equity risk premium is essentially the added certainty investors require from listed equities in comparison to lower risk US government bonds. Put differently: equities should always trade at a relative discount to compensate for the additional risk. According to investment theory, the ERP should widen and narrow as risks for economies and corporate profits and dividends rise and subside.

Usually, this is what happens, though timing and duration of these moves remain anyone's guess during the best of times. Which is why the ERP is usually only discussed by erudite share market experts and detail-minding investment committees. There are no predictive powers to be gained from it and most conclusions can only be accurately drawn in hindsight.

But like with most financial indicators, when extreme levels appear on screens, that's when broader interest is awoken too.

A brief look over our shoulder shows when the ERP peaked in times of general crisis, the timing was right to prepare for the next rally in equities, as happened in 2020, in late 2018, in 2011, and in late 2008. This time around, however, the ERP has not widened significantly as one would have expected given the uncertainty from rapid central bank tightening, rising bond yields, a global mountain of debt and increasing geopolitical tensions.

Over the past two years the ERP has shrunk, and quite noticeably too.

This is the reason as to why many are calling equities "overvalued" or "expensive", because on a relative comparison with US government bonds, they seem pricey with today's ERP at its lowest level since the global bear market of 2000-2002. Graphic below courtesy of Longview Economics.

If history had repeated throughout the past 18 months or so, the ERP should have gone up (wider) not down (narrower) and the impact on equities would have been significant, potentially a la GFC and Nasdaq meltdown back in 2008/09 and 2000/02 respectively. This immediately explains why forecasts for a more dire bear market to develop in 2022 never materialised.

In hindsight.

The problem with today's set-up is nobody genuinely knows why the ERP has shrunk as much as it has, and why it is at the low level where it is today. But everybody agrees today's ERP enigma represents somewhat of a conundrum. To justify it, corporate earnings need to accelerate by 20%, which seems rather unlikely given the outlook of decelerating economic momentum – worldwide.

Another scenario is for bonds to start rallying, strongly, and thus for bond yields to drop significantly. As every investor has witnessed over the past two months or so, the opposite is currently happening. Central bankers are in no mood to allow the inflation genie too much leeway and markets have reset for a higher-for-longer outlook for central bank rates and government bond yields.

We can all see the conundrum, can't we?

If bond yields stay high, or rise even further, and the ERP moves back to the level it was at the start of 2022, equities need to devalue by -20%. This is not taking into account the possibility of economic recessions, and further downgrades to corporate earnings forecasts, or the fact such corrections to the downside always extend further as panic kicks in and more weakness begets more selling, which begets more selling and more weakness.

Don't press that panic button just yet!

As indicated, I have yet to see anyone providing a watertight explanation as to why the ERP has shrunk so much during a time when a much larger premium (larger discount for equity valuations) would have seemed but logical and justified. My own explanation, which I haven't as yet seen mentioned anywhere else, is that maybe the answer lays with the bond market, not with corporates and their equities?

Most equity investors would be oblivious to how horrid the past two years have been for fixed income investors and their portfolios. Many an informed commentator has drawn comparisons with the impact from the GFC or the Nasdaq meltdown on equities. US government bonds are on course for the second year in a row of doubl- digit losses, the third consecutive year of negative return.

As far as we can establish today, this probably has never, ever happened in history.

Is it possible such a terrible time for the less risky government bond market has in effect reduced the gap in risk vis a vis equities?

If the answer is 'yes', this still does not solve the conundrum. After three years of negative return, bond markets are arguably approaching their bottom in pricing and their peak in yields. This automatically implies they become less risky, and overall volatility should subside.

Once this process unfolds, investors will start feeling a lot more comfortable with allocating more money into fixed interest products, including US government bonds.

Can everyone see the conundrum?

If the next step implies government bonds have become less risky and thus the ERP is too low, this cannot possibly be great news for share markets – all else remaining equal. In the absence of a sharp acceleration in corporate profits, bond yields need not simply to come down, they need to pull back significantly to justify today's ERP, but they probably will only do so when triggered by significant economic duress, like a recession.

Another factor that might prove important is share markets are hardly homogenous, both in Australia as well as in the US and elsewhere. While we're all too aware of US indices having enjoyed the benefits from a small group of energy, Megatech, anti-obesity and AI-driven outperformers, on the ASX share price performances to date have equally proven as polarised, leaving many share prices, and valuations, well below the average.

This in itself offers up multiple scenarios and avenues for markets to push back today's ERP to its previous average or thereabouts, if this is what needs to happen. Always dangerous to declare this time is different, but in the same vein: there's no time limit given as by when this process of relative valuation normalisation needs to be completed.

In Australia, as well as in the US, market sentiment and money flows have largely concentrated around companies larger in size, generally speaking. There are always pockets available for short-term traders and market speculators, but generally speaking large caps have outperformed mid-caps, which have outperformed small caps, which have outperformed micro-caps.

And this in a market in which year-to-date total return for the ASX200 is only positive, barely, because of world-class dividends paid out to shareholders.

Another observation is traditional defensives have turned into laggards thus far, which can also be observed through the share prices of Telstra ((TLS)), CSL ((CSL)), Transurban ((TCL)) and Woolworths Group ((WOW)). Rising bond yields have not been the only driver responsible, but they have been a significant and easily identifiable factor.

Equally notable is the remarkable resilience on display from shares in the likes of REA Group ((REA)), Audinate Group ((AD8)) and Pro Medicus ((PME)); stocks local investors simply do not like to dispose of. The same questions surround the winners on Wall Street: is this just a temporary phenomenon, or a loyalty that can withstand further troubles and volatility?

According to Morgan Stanley's fixed income team, the movements in US Treasuries post the September FOMC meeting equal three Fed rate hikes of 25bp each, suggesting the noose is tightening for US economic momentum. In Australia, the RBA is suggesting it may not be done tightening just yet.

At some point, we have to assume, this will be reflected in economic data and in corporate earnings. Bond yields should start trending lower.

The exact timing of events will be of influence to any normalisation in the ERP. Plus lower bond yields will most likely be only one of the factors driving this process, with lower earnings driving lower share prices as a logical co-contributor. Today's markets are heavily bifurcated, implying there are many different ways in which ERP normalisation can be achieved.

While it cannot be excluded this process also includes a nasty, sharp de-rating of equities, exact trigger as yet unknown, we won't know until it has happened because the ERP offers investors nil predictive powers.

Inflation is also still in the mix and a protracted war with reduced supplies of crude oil and gas remains a potential scenario-influencer.

In Australia, the major index is more or less trading in line with its long-term average PE ratio of circa 14.5x. Earnings estimates continue to be under pressure with current market forecast for negative -5.7% EPS growth in FY24, expected to be followed up with a positive 5.7% in FY25.

Average dividend yield is 4.3% only (forward-looking), below the long term average of 4.6%. All aggregate numbers are, as per usual, heavily dependent on what happens with BHP Group ((BHP)) and other miners and energy companies.

To date, the out-of-season reporting by companies in Australia, including investor presentations, quarterly trading updates and AGM outlooks remains a smorgasbord of confirmations, upside surprises and downside adjustments, without providing clear visibility in the underlying economic trajectory for the months ahead.

The sum of all of the above suggests strong and resilient economies for longer may, oddly enough, not be the ideal outcome for equities, but then nobody said the traditional cycle is dead, it might simply unfold at a slower pace this time around.

Conviction Calls & Best Ideas

From Morgan Stanley's asset allocation team:

"Geopolitical events have added to the headwinds for risk assets, which were already impacted by a rising oil price, stretched valuations and a mixed economic outlook. Consistent with our late cycle view, we remain defensively positioned but monitor developments. In the next few months the market could either move up or down within potentially a wide range."

"In the short term, the above factors will likely lead markets to range trade for a while longer. Our Global Investment Committee (GIC) colleagues see a range of 3900-4700 for the S&P 500. In such times of i) high uncertainty, and ii) range trading/volatile markets, income is key as capital growth remains uncertain."

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JP Morgan has zoomed in on A-REITs in Australia. With history suggesting the most likely path forward for government bond yields in the year ahead consists of lower yields (higher prices), REITs should be one key beneficiary.

In particular since share prices in REITs are under pressure in 2023 and valuations, on average, are trading well below intrinsic valuations. JP Morgan's own calculations puts the average sector discount at -17%.

While recommending investors seek to increase exposure to the sector, JP Morgan has upgraded three A-REITs to Overweight; Vicinity Centres ((VCX)), Charter Hall Retail ((CQR)) and Abacus Storage King ((ASK)), while also upgrading Stockland ((SGP)) and Region Group ((RGN)) to Neutral.

Goodman Group ((GMG)) remains nominated as one of preferred sector exposures, irrespective of significant outperformance to date, alongside Scentre Group ((SCG)), GPT Group ((GPT)), Dexus ((DXS)), Vicinity Centres, and Charter Hall ((CHC)).

Interestingly, earlier in the same week sector analysts at Morgan Stanley had conducted the theoretical scenario for higher for (much) longer yields, which would lift cap rates for the sector and could result in asset values shrinking by between -17%-33%.

Investors should note this is by no means Morgan Stanley's forecast, but the exercise does highlight where risks can show up in the sector regarding potential for debt covenant breaches, as well as for self-imposed gearing ceilings, if bond yields continue following their own script.

Most at risk, in order of magnitude: Charter Hall Long WALE REIT ((CLW)), Centuria Industrial REIT ((CIP)), HomeCo Daily Needs REIT ((HDN)), GPT Group, Mirvac Group ((MGR)), and Region Group.

UBS currently holds Buy ratings for Goodman Group, Mirvac Group, GPT Group, HomeCo Daily Needs REIT, Centuria Office REIT ((COF)), Centuria Industrial REIT ((CIP)), RAM Essential Services Property Group ((REP)), and Lendlease Group ((LLC)).

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Shaw and Partners' Large Cap Model Portfolio has increased exposure to ResMed ((RMD)) and Qantas Airways ((QAN)) believing share prices in both have weakened too much on negative news flow.

The Portfolio earlier also reduced its Underweight position vis a vis the local banks via the purchase of additional shares in National Australia Bank ((NAB)) and ANZ Bank ((ANZ)).

The Portfolio sold shares in Altium ((ALU)), Amcor ((AMC)), Brambles ((BXB)), James Hardie ((JHX)), and Macquarie Group ((MQG)). The position in Amcor was sold completely as the packaging company is believed to be facing a tough period ahead on slowing economic momentum globally.

A separate Model Portfolio picking exposure from ASX100 constituents currently has the following selection of stocks: Altium, Goodman Group ((GMG)), IGO Ltd ((IGO)), ResMed, Santos ((STO)), Suncorp Group ((SUN)), Treasury Wine Estates ((TWE)), and Worley ((WOR)).

Among smaller cap companies, the so-called Emerging Companies, Shaw and Partners' current preference lays with Austin Engineering ((ANG)), AuTeco Minerals ((AUT)), Lotus Resources ((LOT)), Paladin Energy ((PDN)), ReadyTech Holdings ((RDY)), and SRG Global ((SRG)).

In Search Of Yield

Bond yields have reached a decade-plus high but many an investor is at a loss as to how/where using this new set-up to their own advantage outside of the wobbly share market.

The following two websites could prove very useful for further research:

https://www.bondexchange.com.au/

https://xtbs.com.au/

FNArena Talks

The weekend past saw me putting on a fancy hat and poking fun at investors and traders alike, edutaining the audience at the Australian Technical Analysts Association's (ATAA) national conference in Sydney.

The presentation was recorded but will be available to ATAA members only for the time being.

Luckily, I used the same slides for an online webinar with ASA chapter members in Ballarat three days prior. That recording (1 hour) is now available via the website as well as through Youtube:

https://www.fnarena.com/index.php/fnarena-talks/2023/10/20/investing-rules-forecasts-principles-delusions/

As per always, paying members can access and download the Powerpoint slides via ANALYSIS & DATA, SPECIAL REPORTS (scroll down on the page).

FNArena Subscription

A subscription to FNArena (6 or 12 months) comes with an archive of Special Reports (20 since 2006); examples below.

(This story was written on Monday, 23rd October, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).

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