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Unexpected returns

Asking simple questions often provides a useful means of highlighting how perceptions can differ from reality when talking about financial markets. For example – over the past 30-years, would it have been better to be an equity investor or a bond investor? Considering the massive tail-winds bonds have had, it probably wouldn’t surprise many people that bond investors in most developed markets have just experienced a 30-year bull market. However, it’s interesting to note that in many regions, since the late 1980s, equities have delivered real returns in-line with – or even higher than – bonds (see UK and Germany examples, figure 1).

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It’s interesting because the ‘only’ benefit of holding bonds over equity over the period as a whole has been much lower volatility (it is also notable that since 2008, cash – the ultimate perceived ‘safe haven’ – has lost value, while both bond and equity investors have made money).  I say ‘only’ benefit because given the macro environment, especially in recent years, investors could have expected bonds to deliver much more than equities. The shock of the 2008 financial crisis ignited a prolonged period of broad-based risk aversion which we are yet to see investors fully shake-off, creating significant headwinds for equities. This has been coupled with central banks engineering a bond rally by stimulating massive demand through extraordinary levels of quantitative easing.

Nonetheless, most investors would probably still feel much lower volatility for comparable returns is the obvious choice. However, we need to look more closely at what has driven these price movements in bonds and equities to see how sustainable this pattern is. I believe bond markets are approaching an important inflection point and fixed-income investors should be a little more cautious and prepared for the possibility of lower returns and higher risk in the period ahead. Meanwhile, equities broadly still look priced for relatively attractive potential returns – for medium-term investors who are willing to tolerate short-term volatility.

What has driven gains for bonds and equities?

Figure 2 shows that market-implied returns in the late 1980s were high in real terms on all assets (in the UK and German examples for equity, bonds and cash). The difference between implied and delivered real returns in bonds and equities reflects very different drivers, and thus may be misleading.

Figure 2

UK Real Returns (p.a.)
Implied (1987) Delivered (1987 – 2014)
Equity 7.62% 5.23%
Bonds 5.39% 5.18%
Cash 4.68% 3.05%
Germany Real Returns (p.a.)
Implied (1987) Delivered (1987 – 2014)
Equity 7.96% 5.50%
Bonds 4.37% 4.66%
Cash 2.00% 1.96%

Source: Datastream, 31 July 2014

Bond investors have fared well because of consistent rerating, rather than improvement in underlying value. In 1987, high interest rates were used to tackle inflation, providing a solid base for savers and keeping bond yields high. As inflation has fallen across developed markets, policy makers have shifted their focus from inflation-fighting towards growth-stimulation. Interest rates have been cut to historic lows and there has been a slide downwards in mainstream bond yields, towards current real levels approaching zero (see figure 3).

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As we have seen, over the past 30-years, real returns on equities have at least kept pace with bonds. However, in the case of equities, returns have been driven by improvement in underlying value (as evidenced by relatively unchanged P/E ratios or earnings yields) through growth of earnings, dividends and corporate value. Figure 4 sows that over the period, for example the UK equity index has risen broadly in-line with EPS, keeping P/E ratios unchanged. Yet equities remain cheaper than bonds. There is very likely a behavioural element to the current above average valuation gap between equities and bonds. Investors often confuse volatility with risk (when in fact true risk would be the potential for permanent loss) and in particular remain emotionally scarred by their experience of the 2008 financial crisis.

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Conclusion

It is impossible to forecast accurately the path of asset prices over the next 30 years, or any meaningful time period. Furthermore, such speculation may prove a dangerous distraction from what really matters – the observable facts in front of us today.

Many areas of the global bond market have been artificially inflated to unattractive levels of valuation and unsustainably low yields. Ultimately, bond yields can only decline so far and the returns on bonds over the coming years are unlikely to match those seen during the 30-year bond bull market since the end of the 1980s. Furthermore, while the return potential on mainstream government bonds looks limited, historically low levels of yield offers less protection from the increased risk of loss. While it is difficult to predict exactly when or how, interest rates will inevitably rise. If this happens gradually, bonds will likely generate only very low returns, but if market participants are surprised by rate hikes, bond investors could incur sudden and significant losses.

Meanwhile, equities remain behaviourally-undervalued. Although equity markets movements over the past 12 or 18 months suggest investors have begun to be less concerned about tail risk, bouts of significant short-term volatility indicate sentiment remains fragile. The result is that equity valuations in selected geographies and sectors remain reasonable, and especially compelling versus bonds, particularly against a broad global backdrop of low inflation, gradual economic recovery and still accommodative policy.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.