2023-03-10 10:36:07 ET
Summary
- Stocks have handily outperformed bonds so far in 2023.
- With interest rates now much higher than a month ago, bonds are attractive investments relative to the overall stock market.
- The key determinant of which asset class outperforms will be the path of inflation expectations and of the Federal Reserve's monetary policy.
- We discuss possible outcomes that are good for stocks and those that are good for bonds.
- Our base case is that the bond-friendly outcomes are more probable.
There is an alternative
The past Sunday's Wall Street Journal headline blared that finally, after many years, there is an alternative to stocks for the typical investor. That alternative, of course, is bonds, presumably either U.S. government or high-quality corporate ones. The chart below shows that in 2023 stocks (SPY) have handily outperformed bonds (AGG), though some of that outperformance has been retraced in the last few days. Interestingly this retracement took place after the Wall Street Journal article was published.
The reason that bonds appear more attractive than stocks can be neatly summed up by looking at the earnings yield of the S&P 500 relative to the 10-year Treasury rate. The top panel of the next graph shows that the 10-year Treasury yield (labeled gt10 ) has experienced a large increase so far this year. At the same time the earnings yield on stocks, E10/P (middle panel), has gone up slightly, reflecting a drop in stock prices from their late-2021 highs.
10-year rates (blue line), E10/P (10-year average earning to price ratio, orange line), and earnings yield relative to rates (green line). (QuantStreet, Bloomberg)
The relative earnings yield, that is E10/P minus the 10-year Treasury yield, reflects which of these two moves has been the dominant one. As the bottom panel in the chart shows, the relative earnings yield has fallen from close to 5% in 2020 to -1% today. This means that for every $100 invested in the overall market, investors currently receive around $3 in corporate earnings, which happens to be 1% or so lower than the current level of 10-year rates. On a relative earnings yield basis, stocks don't look very attractive (a nice academic reference for how the relative earnings yield forecasts stock returns is here ).
At the same time, the higher level of interest rates is a positive forecaster of future Treasury and high-quality corporate bond returns. We wrote a detailed piece about this a few days ago. With bonds relatively attractive because of higher interest rates, and with stocks relatively less attractive for exactly the same reason, investors may be well served by shifting a part of their portfolio from stocks to bonds.
In what set of circumstances would such a portfolio shift do well?
Stock-friendly outcomes
Before turning to the sequence of events that would lead to bond outperformance, let us consider what would need to happen for stocks to do better than bonds, despite high Treasury yields and relatively low earnings yields on the S&P 500.
First, the Fed would need to adroitly manage its rate-hiking cycle to slow economic growth just enough to convince consumers and firms that inflation is indeed under control, while not tightening so much so as to drive down corporate profits. Certainly, this is possible, but the glidepath is pretty narrow.
Second, the upcoming productivity revolution -- that we believe will materialize on the back of advances in artificial intelligence and large language models -- will have to arrive earlier than most investors think it will. While technologies like ChatGPT and Google's Bard have the power to fundamentally transform how many of us work, this transformation is unlikely to happen soon enough to catalyze stock performance relative to very restrictive Fed monetary policy.
International factors, like China's post-COVID reopening, a resurgent Europe, and a surprise early end to the Ukraine conflict, might provide a major boost to risk assets globally, which would lead to stock outperformance.
Finally, it is possible that the uptick in inflation fears that we saw in February of 2023 will simply subside because the Fed has already introduced enough tightening into the economy. A few favorable data points on the inflation front would lead both stocks and bonds to rally, but stocks would outperform in this scenario, since they would benefit both on the earnings and on the discount rate front. This seems to be the likeliest of the stock-friendly outcomes.
Bond-friendly outcomes
The chain of event that leads to bond outperformance relative to stocks would look something like this:
- In response to media, market, and political pressures, policy makers at the Federal Reserve will increase the Fed Funds Rate beyond the level necessary to control inflation and inflation expectations.
- The Fed's increased policy rate will drag up other, short-term consumer and commercial borrowing rates, leading to credit contraction, and an economic slowdown.
- This will lead to slower-than-necessary (i.e., to slow inflation) economic growth which will result in lower corporate earnings, or at least in more slowly growing corporate earnings.
- Earnings headwinds will depress stock prices (less likely) or cause stock price to go up more slowly (more likely).
- The economic slowdown and credit contraction will lower inflation, inflation expectations, and economic growth.
- The combination of lower inflation and lower growth will lead to lower longer-term interest rates, which will lead to bond price increases that are larger than stock price increases.
Summing up
Of course, events may turn out very different than any of the above scenario. But the Fed is under enormous pressure to correct the perception that it was slow to act in 2021 in response to building inflationary pressures. And the narrative that emerged in markets and in the media this part February maintains that inflationary pressures are again starting to build. The Fed is being forced to act to maintain its credibility with markets, and the risk that the Fed overtightens feels very real. If that happens, Treasury and high-quality corporate bonds stand to be the winners.
Arguing against this outcome is the fact that the overweight-bond and underweight-stock trade seems to now be the investor consensus, which suggests that market technicals may serve as headwinds. For an in-depth analysis of these issues, please take a look at my recent webinar .
As always, please make sure to position your portfolio in keeping with you risk tolerance and your liquidity needs.
For further details see:
What Will It Take For Bonds To Outperform Stocks?