Hedley Market Commentary - October 2019

The capitalisation of the global stock market is around $85 trillion. The total amount of global debt outstanding, from sovereigns and corporate issuers is roughly $100 trillion. Of the $100 trillion of bonds, more than $17 trillion have nominal negative yields. When you incorporate the universe of bonds that trade at negative real yields, adjusting the yield for the inflation rate, the number jumps to $25 trillion. That is more than a quarter of all bonds outstanding.

This flight into bonds and ‘safety’ is being made at the expense of much of the equity market, with shares being driven higher by a narrower set of stocks. A total of $16 billion flowed into bond funds in the week to Wednesday, 14th August with Investment-grade bonds sucking in $10.7 billion, the fifth largest ever week of inflows to the asset class, while government bonds accounted for $4.7 billion. Meanwhile, equity funds continued to suffer modest outflows, with $4.7 billion being sold during the week. There are obviously many reasons for investors to worry, from the trade war disputes, Brexit, global recessionary fears, the list goes on but is buying bonds and defensive equities to the point where value is no longer obvious the right move?

So is buying equities the right strategy? Most economists think we are at the tail-end of a 10-year economic expansion and the probability of a near term recession is high. Many strategists forecast that equity returns over the next decade will not match the performance over the last ten years. That may be the case. The possibility of a lower positive expected return for stocks, however, still seems better than the surety of a negative real return offered from most bonds.

One way analyse the relative value between stocks and bonds, is to look at the “equity risk premium”. The equity risk premium is the difference between the earnings yield of the broad stock market and the long-term risk-free interest rate. The broadest measure looks at the MSCI All-Country World Index, which includes stocks of all sizes from dozens of countries, and compares it to the Barclays Global Aggregate Bond Index, which includes investment-grade sovereign, agency and corporate bonds from 24 countries.

On this measure, equities look very cheap compared to bonds, albeit that the world economy is challenging and earnings growth is likely to be subdued for the foreseeable future. It may of course be the case that equities are not so cheap but that bonds are very expensive, Whichever is true, this ever narrowing investment view cannot continue forever, unless of course we really are headed for the ‘Japanification’ of the global economy.