We have previously eschewed the constant refrain of any and every talking head who pounds the table on adding to equity risk on the basis of 'low' interest rates - why wouldn't you earn the higher dividend? or how much lower can rates go? However, aside from the drawdown-risk [9] and empirical failure of the stocks-bonds arguments [10], there are three very pressing reasons currently for reconsidering the status quo of bonds against equities. Volatility in equity markets has been considerably higher than bonds and even at elevated earnings yields, it is no surprise that risk-savvy investors prefer a 'safer' lower-vol yield. Furthermore, when compared to a long-run modeling of business cycle shifts in stocks and high yield credit markets, stocks remain notably expensive to the credit cycle. Simply put, corporate bonds are at best offering better value than stocks if your macro position is bullish (and are forced to put money to work) and at worst suggest being beta-hedged is the best idea (or market-neutral) or in Treasuries.
Morgan Stanley's European credit research group are relatively bullish. While there are a number of reasons, including high saving rates with its accompanying demand for bonds, the chart below indicates bonds (more specifically European, Asian, and US high yield bonds) offer considerably better value than stocks currently when compared to recent volatility.
[11]
They note:
We believe that credit still looks attractive in the global asset allocation landscape, as it has less of a valuation problem than high-quality government bonds do and less of a volatility problem than stocks do today.
Thanks to the negative correlation of spreads and rates, corporate bonds have actually experienced lesser volatility than risk-free sovereign bonds. In fact, even HY credit has been less volatile than high-quality sovereigns.
Not only is the yield and volatility of the asset important from an asset allocation perspective, but also the correlation in a portfolio context. The superior yield over sovereigns but the negative correlation between credit and risk-free rates and the low volatility of corporate bonds is a major attraction of credit from a portfolio point of view.
But, the case for bonds over stocks is strengthened when we consider how each is priced on a recessionary basis. MS is starting from a bullish perspective and putting money to work in the best value asset - which makes sense if you have that macro view - and note that while BBB spreads are notably wider than recession averages, equity multiples are not excessively low by historical standards:
[12]
Furthermore, as Capital Context notes recently [13], the current environment when considered across the cycle suggests that there remains a downside bias for stocks based on their Credit Informed Tactical Asset Allocation Model [14]. The framework compares the perspective of a credit index [15] with an equity index (a stationary non-USD-numeraire mean-reverting index with a USD-numeraire index) to generate signals for asset allocations. Currently, as the chart indicates (the level of disconnect is negative - equity expensive) and as we have also noted for months, credit markets are notably more worried at the reality of our situation (and perhaps more so in real and not just nominal terms) than stocks.
In summary, adjusted for volatility and draw-down stocks are simply not as attractive from a relative-value perspective currently. Cyclically adjusted, credit markets are also priced for more concern than stock markets and thus either suggest being market-neutral in stocks (if forced to hold) or buying high-yield bonds (if bullish as they are priced 'cheaper' than stocks).