It’s All Relative: Stocks And Bonds In A Crazy World

It’s all relative.

That universally applicable old adage (you can always find a use for it no matter what it is you’re talking about) has been a mainstay of the investment case for risk assets in the post-financial crisis era. Stocks too expensive for you? Well, take a look at bonds — they’re expensive. Junk spreads look too rich? Well, high-grade basically gets you nothing in the US and, depending, less than nothing in Europe.

It’s all part and parcel of the hunt for yield engendered by central banks, whose forward guidance underpinned the carry trade in all its various manifestations and, in the same vein, underwrote the short vol bubble. Now, with global stocks headed for their best month in decades and US equities trading at (or beyond) dot-com valuations, the same justification is in play.

Visuals like that one may not tell the whole story. It all depends on how rapidly earnings (and earnings expectations) recover from the pandemic plunge. If Q3 results were any indication, the outlook is perhaps more upbeat than feared. Throw a vaccine (or two) into the equation and it’s possible to suggest that the figure (above) is a Fata Morgana of sorts.

Even if earnings remain depressed and the robust recovery baked into many forecasts doesn’t materialize, we often find ourselves right back parroting the same argument about relative valuations when it comes to recommending an overweight in equities.

“Despite the sharp rally in the equity market, US equities are not expensive relative to USTs,” SocGen wrote, in their global asset allocation outlook for 2021. “The double-digit return for 10y USTs this year came on the back of an over-100bp fall in the 10y bond yield,” the bank added, noting that “for USTs to deliver a similar return, Treasury yields would need to move into negative territory.”

Don’t rule it out — lord knows don’t rule it out. After all, we know the policy rate is not a downside constraint on yields, and in Europe, you’ve got periphery governments (pariahs just eight years ago) borrowing for a decade at next to nothing.

I’d describe opinions on this as “mixed.” There was a time when market participants seemed to believe negative nominals stateside were a foregone conclusion. Alan Greenspan said as much back in September of 2019, for example. You’ll recall that August 2019 witnessed a massive bond rally tied to a growth scare and tariff escalations. That marked the first time the global stock of negative-yielding debt touched $17 trillion. Recently, we hit the milestone again.

Now, though, calls for negative long-end US yields are a bit quieter. “I don’t think yields are going to go negative in the US even though they’ve gone negative in many other jurisdictions,” David Rosenberg told MacroVoices, in an interview last week. “I think the Fed has already told you we’re not going into negative rates.”

If that’s true, it would appear to make SocGen’s case. “The low level of government bond yields as well as the limited extent of a potential fall in yields from current levels indicates low returns from government bonds going forward,” the bank said.

But there’s more nuance to it than that. Average equity volatility is up. And that means risk-adjusted returns are imperiled. “While valuation is an important input in asset allocation decisions, expected volatility of equity is equally important when allocating between equities and bonds,” SocGen went on to write, before noting that in 2020, the average level on the VIX is the highest in eleven years. “As a result, the risk-adjusted return of equity has been below its historical average in 2020, despite the equity risk premium remaining elevated,” the bank wrote.

That said, the VIX did drop below 20 last week for the first time since February, and part of the consensus narrative for a year-end melt-up in stocks revolves around the notion that realized vol will get pulled lower, thus triggering mechanical “buy” flows from vol-sensitive, systematic investor cohorts.

Of course, if you don’t believe in bonds as a diversifier anymore (i.e., if you’re in the camp that questions the validity of 60/40 going forward), then parts of this conversation are irrelevant.

For his part, Rosenberg doubts you should abandon bonds, even if you’re not likely to duplicate the kind of returns seen recently.

“It’s not like you’re going to make gobs of money anymore in the bond market,” he said, during the same interview with MacroVoices’s Erik Townsend. But Treasurys still play a crucial role as a “ballast,” he remarked, adding that “one of the scarce resources globally is safety, and the Treasury market — there’s nothing safer than that.” 

Except for March. When the Treasury market blew up.

Reports Of 60/40’s Demise Were Greatly Exaggerated (Laphroaig Bottle)