Will It Be Different This Time For Equity Returns?

By Jim Picerno, Director of Analytics

Will it be different this time for equity returns?

Comparing stock-market valuations with near-term performance results is more or less worthless, but valuation shows considerably more traction over longer-term horizons. Case in point: estimated price-earnings ratio and subsequent five-year annualized performance for the S&P 500 Index.

J.P. Morgan Asset Management reports in the June 30 edition of its “Guide to the Markets” that the linkage for these two variables is relatively strong. (“Strong,” of course, has a specific meaning with market forecasts and in this case the definition translates to a 45% r-squared, which means that valuation is useful roughly half the time.) Unsurprisingly, lower valuations tend to align with higher five-year returns. It’s not perfect, but it’s strong enough so that ignoring this relationship is, on average, asking for trouble.

By that standard, the five-year outlook for U.S. shares looks challenged these days. J.P. Morgan’s estimate of forward P/E is above 20, which implies a flat performance for the S&P 500 through 2025.

That’s not written in stone, of course, given the standard caveats with forecasts. But if you’re considering relative risk profiles for assets, the odds appear to be in your favor for reducing U.S. equity exposure.

Predicting bond returns

The ancient Chinese sage Lao Tzu is credited for saying: "Those who have knowledge, don't predict. Those who predict, don't have knowledge. " That said, forecasting returns is still a worthwhile exercise. Expected returns, after all, drive market activity and so developing context for expectations with one or more models provides a useful baseline for managing expectations and adjusting portfolio allocations.

The good (and bad) news: there’s no shortage of models to choose from. The latest entry for the fixed-income realm joins a lengthy list. On the plus side: the freshly minted model is a paragon of parsimonious design and inputs. More importantly, the test results are encouraging.

“We find strong and robust evidence of government bond return predictability using a deep sample spanning 70 years of international data across the major developed bond markets,” write a trio of researchers in a new working paper – “Predicting Bond Returns: 70 years of International Evidence.”

The model is relatively simple and uses just four inputs: equity returns, commodity returns, the Treasury yield spread and bond-return momentum. At present the model points to continued gains for the U.S. bond market overall for the near term, based on data through June. If the model proves correct, then interest rates will remain low for the time being.

Is The Fed Running A Yield-Curve-Control Policy For Treasuries?

Unleashing massive deficit spending in an effort to provide economic support for an economy nearly brought to its knees by the Covid-19 pandemic has led some to speculate that the Federal Reserve is intentionally forcing interest rates down to reduce the cost of the debt the government has taken on. In a world of dramatically higher debt burdens, the cost of servicing the debt could be monumental with sharply higher rates.

Enter yield curve control (YCC), a policy that caps interest rates at specific yield targets. As an alternative to the game plan that’s prevailed for much of the past decade -- quantitative easing (buying bonds with newly printed money) -- YCC is thought by some to be a timely alternative monetary tool for stimulating the economy. Skeptics wonder if there are ulterior motives at work.

Either way, the central bank is officially conducting “further analysis,” the central bank’s June 9-10 minutes reveal. Looking at the 10-year yield in recent history, however, suggests the Fed may have already begun experimenting with YCC.

The Treasury market appears to be tracking a quasi-YCC policy for some maturities. For example, since April the 10-year rate has been unusually stable, holding in a tight 0.6%-0.7% range, save for one short-lived spike to 0.91%. Coincidence? Maybe, although with the growing focus on YCC in the U.S. it’s reasonable to wonder whether the Fed is testing the policy without formally announcing it. Or perhaps the market is pricing in its own version of YCC in anticipation that the genuine article will roll out soon.

Jon Hill, U.S. rates strategist at BMO Capital Markets, has suggested that the increased focus on YCC in recent months has “basically meant that the Fed has already accidentally implemented it.” Whatever the explanation, the benchmark 10-year yield has been going nowhere fast lately. Perhaps YCC is the reason why.

Then again, if the 10-year falls through the recent floor, the case for see YCC at work will quickly fade as the market focuses on other demons to monitor.

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