Mind the Gap

Despite increased chatter in markets on the need to adjustment the outlook for the US and European central banks, price dynamics in most parts of financial markets have remained fairly muted recently. A bit more two sided risk to the start of Fed tapering (rather than only risk of further postponement) and further easing by the ECB on the back of lower-than-expected inflation numbers had a clear impact on currency markets (broad based USD strength), but did not alter any of the other market drifts that became visible in recent weeks. Equities continued to trend higher, bond yields and (credit) spreads moved sideways and commodities lost a bit more ground.

With underlying macro and earnings fundamentals and reduced “shock”-fear amongst investors, a further normalization of allocation stances and relative risk premiums remains likely over the next 12-18 months. The latter is actually something that cannot be stressed enough in an environment in which “bubble”-talk or at least increased concern over asset class valuations has gained traction on the back of Central Bank (CB) persistence to keep policy stances unusually loose.

Opinions differ on the prudence of CB stances in relationship to the challenges that they are faced with, but we would argue that the current balance of risks in the macro landscape (more than) justifies the approach taken. Neither large inflation nor high bubble risks are not part of our base case outlook for the future. We obviously cannot exclude these outcomes either, but for now we feel that the macroeconomic environment explain to a large extent why government bond and credit yields are as low as they are and therefore should not be seen as bubble phenomenon.

Still, this part of financial markets has seen remarkably strong inflows in recent years. Especially once zooming into to emerging markets, the fixed income flow dynamics in recent years do point to some risk of flow reversals and re-pricing of underlying risks once the global economy moves to a next phase of its rebalancing act.

The latter only becomes really clear if one compares across asset classes. Risk premiums in fixed income might not be excessively low, but are very modest compared to the reward for taking risk in equity space.

As can be seen in the graph, the premium that can be harvested by allocating risk to equities compared to bonds, measured as the earnings yield minus real interest rate, is still remarkably high.

To those who have seen headlines over new record highs in equity markets or who mainly judge equity market valuations on the back of price-earnings or earnings yields (blue dotted line in graph) it might sound strange to argue that equities are attractive. We would stress, however, that equity and other asset class valuations should always be judged relative to the underlying macro environment and the attractiveness of other investment opportunities.

The former mainly influences the general level of risk premiums across asset classes, which should be lower than during the peaks of the crisis, but still higher than before the crisis due to lingering uncertainties. The latter provides more insight in the relative attractiveness of a certain asset class compared to other at a certain point in time. In this respect it remains noteworthy how large the gap between the earnings yield and bond yields still is at a little under 6%, which is well above average (3.2%) and close to its highs if the Lehman collapse and the peak of the Euro crisis are excluded.

This means that we should not yet be afraid of either broad based bubbles or equity market heights.

Arguably, equity market valuations are still remarkably attractive in a relative sense. Especially, with both cyclical and political dynamics moving in the direction of a further moderation in risk premiums across asset classes.

A gradual further normalization of asset allocation stances amongst global money managers therefore remains our expectation for not only the rest of the year, but also 2014. Not surprisingly therefore we continue to hold equities as our strongest overweight in our asset allocation stance.