A perpetual problem for investors is deciding what assets to allocate to. As US equity values remain sky high, are they still worth the risk? The answer is as multi-dimensional as a Maurits Cornelis Escher drawing, says strategist Peter van der Welle.
The Dutch graphic artist is best known for ‘Relativity’, a stunning depiction of an architectural structure that merges three unique perspectives into one seemingly unified but impossible frame. Today’s markets present a similar conundrum in that both equities and government bonds are experiencing long-running bull markets around the same time. It requires careful navigation to avoid losing money in both, but perspectives on how to make this trade-off differ significantly.
A traditional bolt-hole has been the US, whose world-leading and sometimes gravity-defying economy has long been the engine for global growth and corporate strength. But does this still hold true? One way of judging it is by using the equity risk premium.
Put simply, this describes the excess return investors have received historically, or expect going forward, for investing in equities rather than super-safe AAA-rated government bonds. It is one of the valuation tools that Robeco uses in its Expected Returns framework and is particularly useful in the search for value when bond/equity correlations are about to change.
Historically, stocks have always comfortably beaten sovereign bonds, earning an excess return of 3.2% since 1900. For the US, this return is even higher at 4.4%, compared to a global average of 2.8%. There is also an anomaly in that these rates are consistently higher than the underlying GDP growth would explain – there is some sort of premium on top of the premium.
One interpretation is that the generally higher US equity returns illustrate the country’s status as the global economic and political powerhouse of the 20th century. Equity investors have been rewarded for the US success story. However, this is not borne out by productivity growth data of only 1.83% a year from 1900 – close to a 20-nation average of 1.85%. This drives home the equity premium puzzle: that the link between the real economy and the reward for taking risk in the domestic stock market is obscure.
Relativity – it depends how you see it.
The problem for investors is not the semantics of what causes the size of the equity risk premium, of even where it comes from (demand or supply factors?), but the fact that we appear to be at a turning point. Never in recent history has the US equity risk premium been so low compared to that of the global equity market, which itself is now at its lowest point in 33 years.
This can be seen in the chart below, comparing the US equity risk premium ‘z-score’ – defined as the S&P 500 earnings yield minus the 10-year Treasury bond yield – with that of the equivalent figure for the MSCI World earnings yield minus the Merrill Lynch global government bond yield.
Previous lows in the z-score of the US equity risk premium versus the global equivalent – both of which were less extreme than today’s levels – were seen in March 2000 and May 2006. These troughs signaled the peak of the last two equity bull markets in the S&P 500, preceding them by 3 and 18 months, respectively. So this may provide cause for concern – are we approaching a new bear market?
The bullish interpretation is that ‘this time is different’ because the US is in a much stronger position than it was in 2000 or 2006. Absolute stock market valuations measured in terms of cyclically adjusted price earnings (CAPE) are less excessive than they were in 2000, while US macro volatility is far lower. And unlike in 2006, a housing market bubble is now only a distant risk, real interest rates are much lower, and share buybacks are more supportive.
Additionally, the overall performance of the US stock market is, and will continue to be, underpinned by the strong and stable real profitability of the US tech sector. This has yet to reach the heights of early 2000 as a percentage of global stock market value, and the US administration has no incentive to curtail Silicon Valley, as this would play into the hands of China.
Still, if the so-called ‘Trump Put’ of lower corporate taxes and fiscal stimulus fizzles out, the US economy overheats, or if trade protectionism backfires, this would create elevated macroeconomic uncertainty. So these are competing narratives, and the party may still be over for US market participants.
In summary, as the artist Escher already showed, perspectives matter. Robeco’s analysis suggests that excess equity returns in the US will eventually flatten, or could even fall into negative territory in the medium term, compared to excess equity returns to be had elsewhere.
This means that US Treasuries will remain investible, and diversifying away from US equities to other regions could be rewarded. But a disclaimer is warranted: while this time might not be different in the end, the opportunity cost of diversifying away from US equities too soon – in a world where the US is still the undefeated global financial powerhouse – could be steep.
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商号等： ロベコ・ジャパン株式会社 金融商品取引業者 関東財務局長（金商）第２７８０号
加入協会： 一般社団法人 日本投資顧問業協会