Low yields leave investors with difficult choices
IT IS better to travel hopefully than to arrive. For investors, the hopeful journey started in the 1980s as inflation came under control around the world. Yields came down, prices went up, a simple “buy and hold” strategy could often provide decent returns. Even boring old Treasury bonds returned 9.1% annually between 1982 and 2007, according to a Deutsche Bank study of long-term returns.
At the end of such a journey, though, yields must reach a point where they can fall little if any further. And that explains much of the sorry pass at which investors have now arrived. Almost every asset class seems to be fraught with danger. Equities have suffered two bear markets in just over a decade and remain vulnerable to a rich-world recession; government bonds offer little protection against a resurgence of inflation; commodities are volatile and hostage to a possible drop in Chinese demand; property is still suffering from indigestion after the past decade’s boom.
Savers have to put their money somewhere. But if they make the wrong choice the results could be disastrous for them. History is well stocked with bear markets that wiped out wealth on a vast scale (see table). When British government bond yields were last down to 2.5% (their current level), in 1946, the subsequent 28 years saw them lose three-quarters of their value in real terms. Investors who piled into gold at the last peak in 1980 saw the price fall by two-thirds in the 20 years that followed.
The long bull market in financial assets that brought yields down was due in part to robust fundamentals—steady economic growth and rising profits—and in part to sentiment. As investors grew more optimistic they paid higher valuations for equities and bonds, generating higher returns and thus attracting even more buyers.
But that positive feedback could not last forever. Eventually investors had to face an inexorable logic; the lower the yield on an asset to begin with, the lower the likely long-term return. The first asset class to feel the crunch was equities. By 2000, amid all the enthusiasm for the internet, the dividend yield on American equities was just 1%, an historical nadir. Sure enough, the annual real equity return over the next ten years was just 0.8%.
How low can you go?
It should have been no surprise. If you rank the 75 years on the American stock market from 1925 to 2000 by yield, investors who bought in the lowest-yielding quintile received a subsequent average real return over ten years of 3.1%; those who bought in the highest-yielding quintile got 10.7% (see chart 1).
Now investors are facing low yields across the board. Short-term interest rates are close to zero, except in the euro zone, where they are 1.5%—still a negative return in real (after inflation) terms. Ten-year government bonds in America, Britain, Germany and Japan range between 1% and 2.5%; bonds of shorter maturities yield even less. Even Wall Street, despite its recent weakness, is not offering much of an income; the dividend yield is just 2.1%, well down into that bottom quintile.
Why does the yield matter so much? It is a truism that the long-term return for equities equals the starting dividend yield plus dividend growth (plus or minus any change in the market’s rating). If we assume that American dividends grow in line with GDP, that suggests a real growth rate of perhaps 2.5%, and thus a likely total real return of around 4.5%.
That might be a little optimistic. Profit margins are close to a 50-year high, relative to GDP, and thus seem likely to shrink. Furthermore, the long-term real growth rate of American dividends, according to Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School, has been less than GDP growth: just 1.4%. Adding that figure to the starting dividend yield gives a real return of around 3.5%, well below the historic average.
Furthermore, a rise in yields (assuming no change in dividend payments) implies a fall in share prices. So if the dividend yield were to rise closer to the historic average, real returns for investors would be sent even lower. Deutsche Bank’s long-term asset-return study calculates that if valuations return to the mean, the real return from American equities over the next ten years will be just 0.6%. At the beginning of the great bull markets for equities, such as those that started in 1948 or 1982, yields were much higher than current levels. To buy at today’s low yields, investors need to believe dividends will grow very strongly.
Nor can American investors take much comfort in valuations based on profits or asset values; they too look high. On the cyclically adjusted price-earnings (p/e) measure, which smooths profits over ten years, Wall Street is trading on a multiple of 19.4, well above the historic average of 16.4. According to Smithers & Co, a research firm, the Q ratio, which compares share prices with the replacement cost of net assets, shows the American market trading 44% above its long-term average valuation.
Things look a little better in Europe. Worries about the debt crisis have caused European shares to underperform Wall Street this year, making valuations look rather more attractive. Euro-zone equities trade on a dividend yield of 4.2% and the cyclically-adjusted p/e for the zone is 11, according to Absolute Strategy Research.
Emerging markets have been a disappointment in 2011. Many investors hoped that the superior growth record of developing economies would allow them to outperform markets in America and Europe. But although China and India are still growing strongly, that strength has not translated into share prices; emerging equity markets fell 23% in the third quarter. The result of this decline is that emerging-market shares now trade on a discounted valuation compared with their developed-market counterparts. That ought to be of some comfort to investors, especially given their superior growth prospects.
Should gentlemen prefer bonds?
Government-bond investors seem to be betting on a combination of recession and deflation. In previous recessions, American equities have delivered an average negative return of 15.3% while ten-year Treasury bonds have delivered a positive return of 10.4%. Although government bond yields in America, Britain and Germany may look low, they can go lower; in Japan, which has a higher government debt-to-GDP ratio than the others, ten-year yields are just 1%. Concerns about Greece, Spain and Italy may have pushed investors into the perceived safety of German and American government bonds.
These yields do not give much of a margin for error. The yield on conventional government bonds can be compared with that on inflation-linked debt to get a rough idea of the market’s expectations for inflationary pressure. In America, such calculations produce an expected inflation rate over the next 30 years of just over 2%. The current American inflation rate is 3.8%; the average since 1900 has been 3.1%. As Dylan Grice, a strategist at Société Générale, points out, it looks as if investors are betting on lower inflation than history would suggest despite the fact that central banks are printing money.
Is it possible that something other than sentiment about inflation is pushing yields down? There are three things that might be doing so. At the shorter end of the yield curve, government bond yields are determined by investors’ expectations of the likely level of official interest rates, and the Federal Reserve has all but committed to keeping rates at their current ultra-low levels until 2013.
The use of quantitative easing (QE) to buy government bonds may have been a factor in pushing down longer-term yields. The Bank of England launched a second round of QE in early October, and the Fed has hinted that it might undertake a third round of its programme.
Thirdly, Asian central banks hold government bonds as a way of managing their currencies. To the extent that they see a stable exchange rate as the top priority they may be relatively relaxed about yields and future returns.
It is hard to know whether these factors are temporary or permanent. What will happen when central banks dispose of the bonds they bought through QE, for example? But they add to the uncertainty involved in buying government bonds.
Deutsche Bank’s study suggests that, if yields revert to the mean, investors in 30-year Treasury bonds will suffer an annualised loss of 3.3% over the next five years and 1.3% over the next ten; investors in ten-year bonds will suffer annualised losses of 4.3% and 2% respectively.
Corporate bonds look rather more promising. In normal times companies get higher yields on their debts than governments because they are more risky. But default rates on corporate debt are very low at the moment; in the 12 months to September just 1.9% of issues defaulted, according to Standard & Poor’s. Fears of a recession mean that the spread (or excess interest rate) over government bonds has risen sharply; European high-yield bonds now offer 10 percentage points more than government bonds, according to James Tomlins at M&G, a fund-management group. This suggests rather more of a margin of safety for investors.
Those worried about inflation and looking for a hedge may be more interested in real assets (property or commodities) than in paper ones. Until recently, gold has been a very strong performer; it has been easily the best asset to own since the start of the credit crisis in 2007 (see chart 2).
The problem with gold, and other commodities, is that with no yield or earnings they are hard to value. Demand from Asian countries has certainly pushed up prices; non-oil commodities have trebled over the past decade. But if the economy does start to slip into recession, commodity prices could fall very sharply; they almost halved between March and December 2008. This year they have dropped by around a fifth since February.
Property remains the favourite asset of the retail investor. Ultra-low interest rates have eased the pressure on many homeowners. As a result, our rent-based measure of house prices shows most markets looking overvalued (America is one of the exceptions). But lenders have tightened their standards since the slapdash days of the subprime boom; borrowers need much larger deposits than they used to.
That is making it harder for young people to get on to the property ladder, cutting off demand at the bottom of the market. As the baby boomers retire and seek to realise the value tied up in their homes, supply may start to weigh on the market. Again, the boom conditions of the 1980s and 1990s are unwinding.
There is a good reason why no obvious winner emerges from this Cook’s tour of the asset markets. The developed world can grow out of its debt burden, inflate the debt away or fall back into recession, marked by occasional defaults. Each of those outcomes leads to a different portfolio selection.
Renewed growth would obviously be best, and would favour equities, but at the moment looks difficult to pull off. An unavoidably hazardous attempt to go down the inflation route would be good for commodities and property but disastrous for government bonds. Those bonds would do best if the developed world slumps into recession after all. Savers will have to pay their money and take their choice.