The writer is head of asset allocation research at Goldman Sachs
In early 2022, investors faced a very unfavorable starting point for investing — both equities and bonds were expensive, with valuations near their highest levels in more than 100 years.
At the same time, already elevated inflation continued to accelerate, forcing central banks to tighten policy aggressively. This led to a sharp rise in US yields, which weighed on most assets except the dollar and led to a material valuation reset. Equity valuation multiples have fallen along with rising bond yields.
As we enter 2023 investors are facing a different framework: notably, inflation has peaked and is falling. Historically, this provided some relief around assets, as long as growth remained favorable and recession was avoided. Equities have also seen a turnaround in the recovery of the Covid-19 crisis, particularly in their relative performance against bonds.
This is reflected in low risk premiums around cyclical assets such as equities and subprime high yield credit. Such premiums represent the excess return that current market prices suggest investors are seeking from assets such as equities over government bonds. If it is low, the potential for relative earnings for such assets may be lower.
One measure of premia is the stock market’s earnings yield — a benchmark derived from dividing companies’ expected earnings by share price. It is the inverse of the price-earnings valuation multiple. The cyclically adjusted earnings yield on US stocks is now below 10-year US Treasury yields and the gap between the two is the lowest since 2007.
That investors are accepting a lower yield from stocks than bonds suggests they expect economic growth and better earnings to boost returns. This was particularly so during the 1990s when investors were bullish and equity/bond yield gaps fell to their lowest levels before eventually rising sharply during the bubble burst. dotcom in 2001.
The reclassification of equities against bonds appears to run counter to the general bearish investor sentiment last year. The strength of the US economy combined with the persistence of inflation may help explain this. In fact, with elevated inflation, equities were less risky than bonds – it was the worst year for bond performance in over a century and rate volatility rose sharply relative to equities.
The reset of the risk premium continued this year with strong returns in risky assets due to better news on the global growth/inflation mix. First, the US labor market has remained remarkably resilient, but slowing wage inflation is reducing pressure on the Federal Reserve to tighten aggressively from here . Second, the risks of a European energy crisis are diminishing with a milder winter and falling gas prices. Third, China is reopening faster than anticipated, supporting global growth and reducing inflationary pressures from supply bottlenecks.
But the reclassification of equities versus bonds increases the risk of disappointment for stock investors. New bull markets in equities that outperform bonds rarely begin without significant room for the economy to expand, either because of a recovery from a recession or because of a new growth engine.
The US is likely to expand below trend this year and while growth risks in Europe and China have eased, long-term concerns remain. And we expect relatively low growth in corporate earnings over the next two years with profit margins likely to decline. In addition, there are risks from negative shocks such as a US debt ceiling crisis or further geopolitical tensions.
In contrast, with inflation easing and central banks nearing the end of their tightening cycles, rate volatility is likely to ease. This indicates better risk-adjusted returns in quality fixed income.
But bonds are not without risks. If US wage inflation declines less than expected from here and growth remains resilient, there could be more hawkish Fed surprises. While the mild winter has provided relief on energy supply concerns, there are still risks of stronger commodity prices due to increased demand as China reopens or a colder winter in Europe.
In addition, although EU inflation started to surprise on the negative side, the European Central Bank delivered a hawkish policy message in December. And any change by Japan to current policies to control yields could also lead to more rate volatility in 2023.
For both equities and bonds, competition from cash or money market funds remains strong in 2023 with prospective yields close to 5 percent in the US (much higher than the 10-year Treasury yield at 3.5 percent) and little risk from either growth or rates. .