Hard Choices Ahead for Asset Allocators

Although ETFs have broadened to encompass a variety of actively managed and selective funds based on quantitative models, they remain a market mostly composed of index funds. As a result, our ETF research team has to keep abreast of trends and valuations across the entire cross-section of capital markets here and abroad. This incredible breadth of potential investments normally provides at least one or two sizable opportunities, or at least a couple clear bubbles to avoid, but our hunts for value have turned up fewer and fewer lately. After the nearly simultaneous surges in equities and collapsing credit spreads worldwide, the easy gains have vanished and hard choices await investors.

The spur for this article was a Monday piece by Tony Jackson of the Financial Times, which was republished here on Morningstar.com. I highly recommend reading that column, as it cleverly articulated the very discussions we on the ETF research team have had in recent weeks as we look at potential medium-term investments and especially focus on the most fundamental asset-allocation choice of all: bonds or stocks?

The banking crisis claimed corporate bonds as a victim far before stocks hit their lows. By November and December of 2008, credit spreads peaked as hedge funds and banks dumped their riskier bonds to meet capital calls. The Barclays Capital US High Yield Intermediate Index had a yield above 22% briefly and the investment-grade index moved above 8% yield, all while Treasury bonds sat around 3.5%. These prices reflected a fear of bankruptcy waves that could match or even exceed Great Depression levels and provided an excellent opportunity for anyone who felt the panic was overdone. From November 2008 through the end of September 2009, an investment in investment-grade dollar bonds would have produced a decidedly unbondlike 27% gain, while intermediate junk bonds have rallied a whopping 43%.

Meanwhile, stocks had a severe double dip that saw them hitting Great Depression-level lows on March 9 nearly everywhere worldwide. The sole exception was emerging markets, which never retested their December lows. Since then, the S&P 500 gained more than 56% through September, versus a 72% rally for the EAFE Index, 84% for U.S. small caps, and a mind-blowing 91% run for emerging markets. The higher risk of these equity investments paid off with higher returns in the rebound, but the returns on U.S. credit bonds are comparably excellent after adjusting for their lower volatility and greater income potential.

This brings us to today, and the choice between whether bonds or stocks have the better outlook. The juicy credit spreads have vanished along with the most compelling stock valuations, and government bonds almost uniformly trade at yields that leave little room for a surge of economic growth or inflation. If we continue to muddle through the recovery like we have the past several months, with little economic growth and even less risk of soaring prices, then corporate bonds and equities both offer modest near-term returns. The true distinction of which investment will perform best depends on the macroeconomic risks that one thinks are most likely.

Should inflation return with a vengeance, obviously the fixed nominal coupons of corporate securities will suffer relative to the rising prices and dividends of equities. However, a sudden economic recovery could also crush today's corporate bonds. If employment started to rise and business investment picked up, real rates would need to rise swiftly to prevent an inflationary spiral. While the seven-year benchmark Treasury bond currently sits at a yield of 3%, it yielded more than 5% during much of the 2001-02 recession and could easily return to those levels if economic activity picks up. Should that happen, yields on corporate bonds would need to rise to match, as current spreads are too narrow to absorb all the rise in real risk-free rates, hurting the investment of anyone who hops into investment-grade debt at today's prices.

On the other hand, today's equity prices do include a slight premium on current depressed earnings. This reflects an expectation that revenues will begin to pick up as modest growth returns, swelling the bottom lines of all the companies whose aggressive cost-cutting efforts kept them barely in the black through the first and second quarters. If the recovery fails to catch hold, and we slip into a no-growth state or even deflation, those revenues will fail to materialize and the stock market may suffer a correction. In that case, the modest nominal returns of corporate bonds look pretty good, especially since the revival of investment-grade debt markets has substantially reduced the risk of defaults due to liquidity crunches.

The outlook is still quite hazy. We do not know which of these scenarios is most likely in the next year or two, so we have been focusing more on the superior long-term returns of equities. Developed markets overseas offer slightly better valuations than the U.S. or emerging markets, along with some protection from a falling dollar for those who fear the U.S. debt overhang. But that, I'm afraid, is another column entirely.

 

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