At times of higher market volatility we believe it can pay to step back and assess valuations within longer historical time periods.
The most extreme moves in recent weeks have been in the bond market. This has had large implications for relative valuations within equities. As bond yields fall, bond-like equities typically outperform.
We find most bond-like equities to be overvalued today. We believe the most interesting and undervalued parts of the stock market tend to be found in those companies that have not benefitted as bond yields have fallen. The gap in relative valuation between these two categories is now the widest in history.
Given the power of the bond market in driving this valuation dispersion, it is worth trying to assess how low yields are today, from a long historical perspective. This can help us identify whether it is prudent to expect yields to fall further.
Below are German 10 year yields from 1809 to today. As can be seen, prior to 2010, German 10 year yields had never traded below 3%. The current level of -65bps is obviously uncharted territory. In standard deviation terms -65bps is approaching -3 SDs from the post war average yield. This is what can happen when risk aversion is historically high and the central bank is pushing in the same direction.
Here are French 10 year yields from 1756 – 2019. It is a similar story to Germany. Yields have never been this low in 250 years.
It is clear that European sovereign bonds have never been more expensive. How expensive are European bonds compared to European equities? Whilst it is not fair to say all equities are historically cheap in absolute terms, they have never been cheaper compared to bonds.
Below is the German equity market’s dividend yield minus the German 10 year bund yield from 1932 to today. As can be seen, it is rare for the equity market dividend yield to be higher than the bond yield. Today equities give investors 4% more in cash dividend terms than bunds per year. Over 10 years that is close to a 50% higher return.
The same is true of French equities vs French bonds today.
These extremes between bonds and equities are reflected in the difference in valuation between bond-like equities and non-bond like equities, eg banks. Banks tend to be vulnerable to deflation and suffer as rates fall, so they have de-rated as bonds have rallied.
Below we show the price to book of Nestle vs Soc Gen. Nestle is now 22x more expensive than Soc Gen in book value terms.
Soc Gen now has a dividend yield of 10.2%. Nestle’s dividend yield is 2.5%. Soc Gen is now on a PE of 5x, Nestle 24x. These valuation gaps are unprecedented over all time periods.
Can we measure the scale of the recent flight to safety in more specific terms?
One way of trying to show investor appetite for bonds is to assess changes in the term premium. The term premium is the component of the yield that does not represent inflation or growth. Historically it has usually been a positive number to compensate bond investors for the risk that today’s perception of long term inflation and growth is wrong.
The term premium for US 10 Year Treasuries is now the lowest in recorded history at -124 basis points. Investors are not preoccupied with positive returns, safety comes first. This is another way of saying US Treasury 10 year yields are 124 basis points below the long term nominal growth rate of the US economy.
What does all this mean?
The flight to safety in recent months has been extreme. This reflects investor anxiety that central banks are out of ammunition. We have sympathy with this view in Europe but that does not make us bearish. Central banks stepping back is a welcome development – we look forward to the day when they give up trying to force the yield curve down. This moment is approaching.
Governments still have levers to pull to lift growth. Mario Draghi was vocal in calling for more fiscal stimulus and we see spending as the prime mover for the economy in the coming decade.
This makes for an interesting set up for markets. There is a bubble in safety, and a crash in growth expectations. Markets are not vulnerable to deflation. The risk to current pricing is inflation. We believe this is an historic opportunity to buy cheap short duration equities and an historic opportunity to sell long duration bond-like equities, and sovereign bonds themselves.
Sources:
National Bureau of Economic Research, Federal Reserve Bank of St Louis, Federal Reserve Bank of New York, Bundesbank, Banque de France, Bloomberg
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