30 Oct 2012 Are Equities now more risky than Bonds?
Since the onset of the financial crisis in 2008, investors became more afraid of the return “of” their money than the return “on” their money. They flocked in droves out of equities into the safe havens of cash and bonds, mostly US Treasury Bonds. Graph 1 below shows the cumulative net inflows into Bonds exceeded $700bn, whilst the net outflow from equity markets was $570bn. As a result the US 10 year Treasury Bond yield dropped from over 4% in 2008 to 1.4% in July this year and US equity markets have not fully recovered to their all-time highs reached in 2007.
Graph 1: Cumulative US Equity and Fixed Income flows ($US bn)
When we try to determine whether equities are cheap or expensive we use the P/E ratio or Price/Earnings ratio. When we compare it to bond and cash yields however, we use the Earnings Yield (EY) which is just the inverse of the P/E ratio. The EY on the MSCI World Equity Index at 9% is currently at historically high levels. This means that equities are cheap relative to historical EY. The reason is that share prices increased less than profits or earnings increased. (If earnings increases are matched by price increases the EY will stay the same).
Because real bond yields (the nominal yield minus inflation) are actually negative, the equity risk premium as shown in Graph 2 is even bigger than 9%. The risk premium is the extra yield investors demand to invest in “risky” equities compared to “risk free” bonds. The average risk premium over this whole period was less than 4%, compared to the current 9%. Is this realistic? Are bonds really risk free?
Inflation in the US is currently higher than the bond yield, so you are guaranteed to earn less than inflation. There is also the real danger of capital depreciation if bond yields should start to rise once the US moves into a higher inflationary era. Inflation for the US is a very attractive option to grow out of their debt. Research has shown that a 5.5% inflation rate will reduce debt by 25% in 5 years. The US does not have to fear that higher inflation and a resultant weaker currency will increase their foreign debt as is the case with other countries, because all their external debt is in Dollars as well.
Investors will have to seek higher yields than they can get in bonds and cash to protect from the eroding effect of inflation. This will eventually drive them back to equity markets. Early movers will be well rewarded.
– Gerhard Lampen
Head, Sanlam iTrade