Income investors should consider lower returns from equities relative to bonds compared to the past few years, according to Stephanie Flanders, chief market strategist for J.P Morgan Asset Management, who thinks current valuations make them less attractive.
Equities have overwhelmingly outperformed bonds in most developed markets over the past five years which has been reflected in the relative performance of the different Investment Association fund sectors.
According to FE Analytics, the average fund in the IA UK All Companies and IA UK Equity Income sector has at least doubled the average return in the main bond sectors. The varying fortunes are particular apparent from 2013 onwards when equities began a substantial rally thanks to improving data and other signs of a recovery from the financial crisis.
Performance of sectors over 5yrs
Source: FE Analytics
Flanders, former economics editor at the BBC, still forecasts that equites will offer decent returns in certain areas of the market but warns that the relative case for being overweight equities within a portfolio is weakening.
She says while over the past few years equities have become gradually less attractive because they have become more expensive relative to bonds, they have still looked like a far better which has driven investor demand.
"You were getting much more return from your equities than you were from your bonds with their yields at such extraordinarily low levels. The earnings yield on equities versus corporate bond yields had a big gap and they were a lot more attractive but in the past few months the numbers have seen quite a significant change.”
“You have broadly the same earnings but quite a sharp increase in corporate bond yields and so the gap is narrowing. That is the measure of the relative attractiveness of equities. At this stage in the cycle you would expect that relative case for holding equities would decline. We can see that the valuation of equity market is looking less attractive”
“The market is not cheap. It is above its long term average in terms of valuations but we are still in an environment where the US is raising interest rates because growth is strengthening and the recovery is feeling more self-sustaining. It feels like a world where the macro fundamentals are quite supportive for equities still but in a more muted way than in the past few years.”
Flanders says investors should expect, with lacklustre economic growth as well as rising interest rates which many have expected to wreak havoc in the bond market, far lower returns from equities than they have seen over recent years.
“Expect less of everything, except volatility. But some volatility is healthier than none at all,” she said.
However, she adds that the difference between bond and equity yield is narrowing and therefore fixed income is more attractive, relatively.
AXA IM's Chris Iggo, chief investment officer for fixed income, is not convinced and is remarkably bearish on bonds.
“Certainly in the traditional fixed income sectors there is not much yield but short-termism and the modest widening we have seen in credit spreads in the last few weeks will see money flow back in,” he said.
“Thus, the fixed income contradiction will return – supposed safety of the asset class leads to crowded positions chasing too low yields with too little liquidity to get out when things change. And, by the way, returns will be low. Year-to-date, most bond asset classes have delivered negative total returns.”
Data from the latest Bank of America Merrill Lynch (BofA ML) Fund Manager Survey found that managers where not losing their appetite for equities, despite the rising yields of fixed income in many markets.
The survey of 191 asset allocators found that 42 per cent are overweight equities up from 38 per cent last month while bond allocations have dipped down to 60 per cent being underweight, from 58 per cent last month.
However, a bearish tone was demonstrated in certain respects with respondents hiking cash and looking to traditional safe havens in a materially higher proportion.
BofA ML’s data found cash balances are at their highest since the collapse of Lehman Brothers – widely seen as the catalyst for the global financial crisis in 2008. The last period when cash was as high was in November 2001, following markets torrid time following the dot-com collapse.
Also, the net proportion of fund managers taking out ‘protection’ against equity market falls in the coming three months is the highest since February 2008. Investors also have described gold as being ‘undervalued’ for the first time in five years.”