Brian Tora takes a look back at historical trends as he considers the yield gap amongst other measures to assess the relative value of equities and bonds today.
When I started out in the investment business, more than half a century ago, the choice of assets available for private investors’ portfolios was very restricted. Cash, British Government securities (or gilts as they are better known) and equities was all there really were. Moreover, the cash would be just in sterling, while the equities were almost exclusively domestic as the dollar premium made investing overseas extremely expensive.
Today our choice is much wider – not just geographically, but in terms of the nature of the assets that can be utilised. Infrastructure, private equity and property, as examples, can enjoy different characteristics to other asset classes, not to mention the way in which bonds have become divided into a whole range of sub classes. Even so, the main comparison that asset allocators continue to use is the relationship between equities and bonds and valuation levels on an historical basis.
The yield gap
Probably the most quoted comparator is the so called yield gap – the difference between the yield on equities with that of gilts. It hasn’t always been a yield gap. For a lengthy period gilts yielded more than equities, creating a so-called reverse yield gap. This came about in the years following the Second World War when occupational pension schemes were becoming increasingly popular and creating an important role for themselves in the investment world.
Until the 1950s, pension funds tended to look upon gilts and property as the only suitable investments. But inflation and the propensity of well-managed companies to increase their dividend payouts to shareholders regularly increased the attraction of equities to pension fund managers. The shift in relative valuation levels was dramatic. According to the Barclays Equity Gilt Study 2017, which looks at investment returns since 1899, equities outperformed gilts by 9.2% on an average per annum basis during the decade to 1956 and by 8.1% in the following decade.
Before this re-rating took place, equities were expected to deliver higher income returns as a reflection of the greater risk they carried. But an increasing demand for equities drove their yields down, while inflationary fears pushed gilt yields higher, resulting in negative total returns throughout the two decades until 1976. Indeed, in the mid 1970s, gilt yields approached 20% as inflation rose to around 25% at one point. Equities suffered too, but not to the same extent.
The reverse yield gap prevailed until the financial crisis of 2008. Then, a flight to quality and muted inflationary fears pushed down gilt yields, while initially equities suffered hugely. The yield gap was restored and has prevailed ever since, with the yield on ten year gilts just 1.2%, while that on the FTSE 100 Share Index stands at 3.7% at the time of writing. Dividend growth continues, though, at a pace that is close to the average over the last half century of a little over 5% per annum – well over the rate of inflation.
Are equities overvalued?
If historic comparisons over yield differentials supports the case for equities against bonds, longer term trends in price earnings multiples appear less favourable. By the end of April the P/E ratio, as it is commonly known, on the Footsie stood at over 30 times – well above the long term average, though distorted by lower profits from resource stocks. However, strong profits growth or recovery will be needed to sustain this valuation. In the United States this particular criteria is even more stretched. The election of a perceived business-friendly president has brought renewed optimism amongst investors, though it is far too early to determine how successful he is likely to be.
The P/E ratio can be best described as representing the number of years a company will need in order to earn its current share price at its present level of profitability. A high P/E is likely to suggest expectations of strong future profits growth. Another way of expressing this particular measure is through the earnings yield – what a company would pay out in dividends if it returned all its profits to shareholders. The earnings yield on equities is way above the yield on gilts.
Room for correction
What should we read into the current valuation criteria for equities and bonds? Probably that there is room for a correction in both markets, but that there is little evidence of the conditions for a full scale bear market in equities. We should not take too much comfort from this, though. Bear markets generally start when shares are at a high point and optimism reigns. Conversely, the time to buy is at the low point of a bear market, but nobody rings a bell at the bottom.
The main risks seem to be rising interest rates, something that has already started in the US, admittedly gently, the stalling of the global economy or a geo-political event of some magnitude. Rising interest rates would take the wind out of the bond market’s sails, but may not impinge on equities. An economic slowdown could lead to a reversal of interest rate rises and more support for bonds. As always, nothing in the investment business is certain.