With both the S&P500 and Treasury prices hitting record highs as recently as one week ago, many have been confused (perhaps none more so than Goldman’s clients as we reported yesterday), although the conventional fallback explanation that has again emerged, is a reversion back to the “Fed Model” according to which the lower yields go, the highest equity multiples should (and may) rise.
As a bearish Goldman explained, “bullish investors argue that sustained low rates will support P/E multiples of 20x or more. The Fed Model relates the earnings yield (5.7%) to the Treasury yield (1.5%). The current 420 bp yield gap is near the 10-year average. Exhibit 2 shows the sensitivity of this model. Assuming a steady bond yield, reversion to the 35-year average gap of 250 bp implies a S&P 500 year-end level of 3075 while the 5-year average gap implies 1900.” For the record, Goldman is not a fan of a 3,000+ S&P target, and instead expects the market to drop in the coming months (details here).
But while at this point nobody really knows what happens to stock prices from here on out, mostly as a result of “helicopter money” now entering the inflation, bringing with it the spectre of runaway inflation and a decoupling of long-bond yields, which implies a sharp steepening of the yield curve, one bank that disagrees that one should buy both bonds and stocks in a perverse feedback loop is Morgan Stanley, which in its Sunday Start note writes that “over the last 17 years, 10yr government debt in the US, Germany, the UK and Japan has produced a better return than the local equity market, with lower volatility. Over the next 10 years, our long-term return models suggest something different. Based on our expected returns for both bonds and stocks, and using historical volatility, 10yr government debt will post worse Sharpe ratios than equities (or credit) over the next decade.“
Maybe, maybe not. Many have tried (and been carted out), trying to short global bonds only for these to hit record low after record low. There is a reason why shorting JGBs is called the widowmaker trade.
However, while MS may again be premature in calling a bottom to global bond yields – after all central banks around the globe are hardly done monetizing debt by a long shot – Morgan Stanley’s Andrew Sheets does bring up a valid point, namely that bonds are no longer a proper “diversifier” to an equity portfolio for the following reason:
We often think of bonds as natural shock absorbers, ‘zigging’ when the market ‘zags’. It’s important to remember this wasn’t always the case. How could this change? One way would be if yields simply don’t have enough room to fall further to offset equity market declines. Take a 60/40 portfolio constructed today from the S&P 500 and US Treasuries. To make up for a 10% decline in the equity market, Treasury yields would need to go… negative. Not impossible, but certainly a high hurdle! We think investors in European and Japanese bonds are seeing a clear example of this dilemma, with Bunds and JGBs simply unable to rally enough to offset recent equity market declines.
Which implies two consequences: either equities indeed selloff, and the result is another rush to safety in Treasuries, one which finally sends US paper into negative yield territory along the rest of the developed world, or equities spike as a result of unwound bond longs. However, this too carries a major risk. Recall that Goldman calculates that even a move as small as 1% higher in US yields would result in MTM losses across the board of $2.5 trillion. And that’s just in the US. That loss in itself could be the catalyst for the next equity selloff and the subsequent scramble back into safety. Or a rather unpleasasnt catch 22 if you will.
How does this play out? We don’t know, but it once again confirms just how trapped the Fed truly is.
Meanwhile for those curious about MS’ latest cap arb thoughts, here is the full Sunday Start note from Andrew Sheets.
New Diversifiers Needed
Two weeks ago, in a sales meeting here in London, a trader mentioned that they were bullish on German Bunds and saw “value across the curve”. This is an asset, I’d remind you, where you effectively give the German Government EUR 100 today and they give you EUR 99 back in 2026. On our group’s long-run return models, buying a 10yr Bund today is roughly equivalent to buying the S&P 500 in November 2000. ‘Value’ isn’t the first word to come to mind.
The difference, of course, was down to horizon. Our trader was likely thinking in ‘days’, and to his credit, was completely right. Bunds rallied defiantly into that weekend despite a strong payroll report. Yet for those required to take a longer view, rich bond valuations challenge a fundamental premise of asset allocation. Bonds are widely viewed as portfolio diversifiers. They have been exceptionally good at this role. Can this continue? And if not, what are the alternatives?
Let’s start with quantifying the problem. Over the last 17 years, 10yr government debt in the US, Germany, the UK and Japan has produced a better return than the local equity market, with lower volatility. Over the next 10 years, our long-term return models suggest something different. Based on our expected returns for both bonds and stocks, and using historical volatility, 10yr government debt will post worse Sharpe ratios than equities (or credit) over the next decade.
But bonds weren’t only great for their Sharpe ratio. They were also unusually good at buffering equity market moves. Between 1950 and the late 1990s, the correlation between the S&P 500 and US Treasuries was positive (equities up, bond prices up). But since then, this correlation has become negative (equities down, bond prices up), providing additional diversification. We often think of bonds as natural shock absorbers, ‘zigging’ when the market ‘zags’. It’s important to remember this wasn’t always the case.
How could this change? One way would be if yields simply don’t have enough room to fall further to offset equity market declines. Take a 60/40 portfolio constructed today from the S&P 500 and US Treasuries. To make up for a 10% decline in the equity market, Treasury yields would need to go… negative. Not impossible, but certainly a high hurdle! We think investors in European and Japanese bonds are seeing a clear example of this dilemma, with Bunds and JGBs simply unable to rally enough to offset recent equity market declines.
We should be clear that investors will continue to buy government bonds. They are liquid, meet important regulatory requirements, and have continued to outperform expectations. Given our economists’ expectation that growth disappoints over the next 12 months (for their latest thoughts on this, please look out for our Summer Outlook, publishing later today), bond yields could remain well-supported despite rich valuations. But for those with a longer-term horizon, we think it is important to think about other tools for diversification.
So where can investors find these ‘new diversifiers’? Our goal is to look for assets that outperform in down markets, come with reasonable drag when times are good, and trade at valuations that are less extreme than what is found in global duration. Swapping government bonds for high-quality credit, allocating to FX ‘safe-havens’ (e.g., USD, JPY and CHF) and owning defensive equity factors (e.g., long large caps vs. small caps in Europe) are several strategies that we think show promise.
Most surprisingly, our work suggests that selling volatility can be a better diversifier of a portfolio than buying volatility, due to high volatility risk premiums that have persisted post the financial crisis. The timing does not look ideal (the VIX is below 13), but the point is clear: unusually rich bond valuations mean investors will have to go farther afield to find diversification.
via http://ift.tt/29ZrX8j Tyler Durden