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Well, if Citigroup’s global equity strategist was at all still prevaricating on which side to take in the bond-stock decoupling conundrum, he’s firmly made up his mind now.
On Thursday Robert Buckland writes that the 40-year cult of equity is — quite simply — dead:
Equities in Japan and Europe trade on dividend yields higher than their respective government bonds. That is only 10% away on the S&P. Of course, this derating of equity against bonds reflects current double-dip and deflation fears, but it also a profound reassessment of both asset classes. The cult of the equity is dead. Long live the cult of the bond.
And he thinks there is little hope of it coming back any time soon:
It will take more than the avoidance of a double-dip to turn the equity outflows around. Sure equity prices would probably rise in the short term if that were to happen, but a sustainable rerating could only be achieved if investors were to be attracted back to the asset class. Although likely to be painful in the short run, an inflation-inspired global bond sell-off would probably offer the best chance of that happening. That still seems pretty unlikely for now.
Now, there are several reasons for the passing of the Cult according to Buckland, who dates its birth to the 1950s, when the equity dividend yield dropped below the bond yield.
One is poor profitability — since 1999 global equities have returned a total of just 4 per cent — another is volatility — two 50 per cent bear markets in the past decade — and this:
It is argued that bonds are more appropriate in a world where deflation, not inflation, is the main threat. Liability Driven Investing (LDI) advocates usually promote the liability-matching benefits of bonds over equities. Ageing populations would seem to favour bonds over equities "” most "lifestyle" pension schemes automatically switch equities into bonds as a worker approaches retirement age. Perhaps most importantly, bonds have handsomely outperformed equities in the past decade. Since 2000, global equities have returned 4% (0.3% per year), while global government bonds have returned 103% (6.9% per year). The list of factors favouring bonds is as long as that favouring equities back in the 1990s.
Whatever the root cause there does appear to be a long-term shift in investor appetite for equities and bonds:
Investor appetite for global equities is falling. Figure 3 [below] shows that in 2009 US private sector pension funds held 55% of total assets in equities compared to 70% in 2006. Figure 4 [below] suggests that UK pension funds cut their equity weighting to 39% in 2009, down from the 76% high in 1993. The 2009 rebound in equity prices has helped to reverse some of this decline in equity weightings, but most investor intention surveys suggest that the secular reduction in equity weightings is likely to continue.
Now, here’s where things get a bit scary.
If there was a reduction in equity holdings back to their pre-1959 levels (that’s around 20 per cent in case you were wondering), there would be considerable selling pressure, says Buckland. US private sector pensions funds alone would have to reduce their equity holdings by $1,900bn.
And there would be other profound implications for the global economy and markets. Says Buckland:
The demise of the equity cult will continue to have profound implications for the global economy and markets. It is likely to keep capex levels subdued. Why bother to build when you can buy existing assets cheaply? Mega caps are likely to trade at discount valuations until they show a more meaningful intention to address their equity oversupply problems, perhaps through buybacks or breakups (or preferably both). They were quick to exploit the rise of the equity cult, but have been slow to respond to its subsequent demise
A case in point is Vodafone, which went on a huge acquisition spree during the TMT bubble using its overvauled paper to build a global empire. However, its shares have languished in the doldrums and are likely to remain there, says Buckland, unlike something radical happens.
Many mega-cap CEOs think that their low PE reflects market concerns about growth prospects. But maybe it is more basic than that. They (or more likely their predecessors) issued too many shares in the late 1990s when their equity valuations were high. They have been reluctant to redeem those shares now that their valuations are low. Consequently, there is an ongoing share overhang, which conventional equity investors just do not have the firepower to absorb. Until mega-cap CEOs recognise this and begin to buy back truly meaningful amounts of their equity (something that most remain reluctant to do), they will likely continue to languish at lowly valuations. For now, many are more inclined to buy their smaller competitors for cash, a strategy that will only further widen the valuation gap between them and the rest of the market.
But enough of all this doom and gloom, let’s end on a positive note.
Buckland says there is one refreshing exception to these trends — emerging markets:
Investor appetites for equity remain healthy. Equity financing is competitive relative to debt. Capex is booming. Larger-cap stocks are not under consistent pressure to break up. It all feels very 1990s "” companies and investors should enjoy it while it lasts.
Related links: Die Hard, with a vengeance - The price of everything James Montier on the bond bubble – FT Alphaville The bond-stock decoupling is quite the Conundrum, Citi says – FT Alphaville
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