Chief Investment Strategist
Summary: While US equity valuations are high, equities still offer a better long-term return than government bonds when considering the "real" return after accounting for inflation. The high equity valuations suggest lower future returns, but it is not an exact science. Adding dividend yield, buyback yield, and expected GDP growth estimates a 5.9% annualised real return for equities. 10-year government bonds currently offer a 1.5% real annualised return. The "real equity risk premium" (compensation for holding riskier equities) is lower than the historical average but still positive compared to bonds. Historically, equities have outperformed bonds, compounding wealth creation over time.
Since the bottom around September 2022 US equities have staged an extraordinary comeback which has pushed equity valuations from below the historical average to levels seen during the 2000 dot-com bubble and pandemic technology rally in 2021. Traditional equity valuation models like our model incorporating several different valuation metrics are good for identifying stretched sentiment in equities but not good to capture long-run return expectations. More importantly, equities are impacted by bond markets because the bond market sets the cost of capital, and thus judging equities in isolation when forming long-run return expectations is not a good idea.
However, if we start our analysis about US equities and whether a storm is brewing because sentiment has been stretched to levels that US companies can hardly deliver on, then let us start with looking at how equity valuations in isolation translate into future returns. As the second chart shows, the higher the equity valuation is the lower the future 10-year annualised real rate return becomes. Of course, it is not an exact science as the prediction interval lines suggest. At the current equity valuation, the predicted 10-year annualised real rate return is expected to be negative, but as the upper prediction line suggests, the return could be positive after all.
One of the shortcomings of this approach is that the combined valuation metric will have a bias related to the chosen metrics and underlying shifts in equity sectors may not be captured well in this model. It is also not the preferred way to form long-run equity return expectations. Let us move to the more proper method and also incorporate those expectations relative to the bond market.
The preferred method to form long run equity return expectations are done by adding the current dividend yield and estimated buyback yield. For the S&P 500 the current dividend yield is 1.5% and the 2-year average buyback yield is 2.2%. For many multinational companies it is more tax efficient to return capital to shareholders through buybacks than dividends. These two figures equate to a combined capital return yield of 3.7%. Assuming these capital return estimates can be held over a 10-year period the capital return yield should grow with long run expected real GDP growth. This is estimated to be around 2.2%. Adding the long run real GDP growth and the capital return yield equates to an annualised real expected return of 5.9% at the current level and under the assumptions described.
In the bond market things are a bit easier because the return is known in advance. The current 10-year yield by the end of January was 3.91% and US 10-year zero coupon inflation swap was 2.46%. The inflation swap market is a hedging market in which market participants can swap cash flows based on the CPI Index and subtracting the swap rate from the US 10-year yield gives the investor a real return on bonds. In January, the market priced real return on US 7-10 year treasuries was 1.46%. Compared to 5.9% in equities investors are not offered the better deal in the long run in government bonds. The difference is called the real equity risk premium. In other words, how much are you as an investor compensated for taking equity risk (uncertainty about economic outlook, productivity, innovation, bankruptcy, and balance sheet).
As the chart below shows, the real equity risk premium has shrunk to low levels for the period since 2006 and it is arguably lower than the historical average. But if you as an investor care about long run returns and accumulating wealth then the US equity market is still offering a better deal than government bonds. When we look at the chart it also become clear why the equity valuation chart in isolation is difficult to use. In late 2021, equity valuations were very high and one could have made the conclusion that equities were bad in the long run from those levels However, in real equity risk premium terms equities offered a spread of 6%. How is that possible? At the time the US 10-year yield was as low as 1.4% and the 10-year inflation swap was at 2.7% translating into a negative real return of negative 1.3%. Yes, equities were overextended and there was a bubble in certain technology segments, but the biggest bubble was in government bonds because it did not adequately price inflation risks.
When interest rates started rising in 2022 on the back of the Fed’s aggressive move on policy rates, bonds plummeted pushing up the cost of capital. The only natural reaction in equities was lower equity valuations, but also because higher interest rates were expected to push the economy into a recession. That did not happen, and US equities have since moved to new all-time highs in total return terms while US 10-year government bonds are still in a drawdown confirming where the real bubble was.
For the long-term investor a final observation is important to understand. The US equity market has returned 9.1% annualised since December 2004 and US 7-10 year government bonds have in the same period only delivered 3.4% translating into an equity risk premium of 5.7% annualised. Compounding in equities is magic for wealth creation. Bonds still play a role in asset allocation and in private investor portfolios. Especially, as the investor ages and has less time to recoup large drawdowns which are part of the risk you assume as an investor in equities.
Explainer of inflation swaps: If the current 10-year inflation swap rate is 2.5% and you go the swap then get a return stream if the realized CPI Index ends up higher than 2.5% annualized over the 10-year period. In other words, if inflation ends up at 3% over this 10-year period then your real rate return on your bonds would have been 0.5%-point lower compared to the prevailing expectations when you invested but by going long the inflation swap you get the lost 0.5%-point back from the hedge. In normal language, an investor can lock in the 10-year forward real return in US treasuries. Quarterly Outlook
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