The writer is global head of multi-asset for BNP Paribas Asset Management
So far this year, an investor in a portfolio of 60 per cent global equities and 40 per cent government bonds would have lost a bruising 14 per cent. This is a far cry from the 9 to 10 per cent they would have grown accustomed to making on average over the past four decades.
These losses would also be the steepest incurred over this period — even if less bad than at the low point in June when they stood at almost minus 20 per cent. Has the sweet spot afforded by a “60/40 book” since the mid-1980s — one characterised by firm double-digit positive returns and much less volatility than investing in equities alone — turned sour?
There are reasons to argue it may have done. As central bankers reminded us at Jackson Hole last week, inflation is back to average rates last seen between the early 1960s to mid-’80s, and monetary policy is tightening aggressively. Labour bargaining power has returned for the first time since that period and, along with fiscal profligacy and fragmenting global supply chains, it is challenging the structural forces that preserved a four-decade bull run in government bonds.
Furthermore, in both the US and Europe, government yields today lock in relatively low prospective returns, and possibly high prospective losses. During the 1960s, ’70s and early ’80s it was much better to own risk assets coupled with cash rather than bonds and it isn’t hard for contemporary asset allocators to see these parallels.
This precarious set-up has made active tactical asset allocation particularly important. BNP Paribas Asset Management’s asset allocation portfolios have been meaningfully short of duration and neutral equities for most of this year. These are tactical positions that would have carried heavy losses in recent history, yet they have been particularly helpful in 2022. For us, every dip in yields has provided an opportunity to deepen our longer-term caution on bonds, and every rally in risk appetite has been a prompt to build more nuanced equity bets.
Notably, movements in equities and bonds have been intimately linked. Forward equity valuations have moved in tandem with bond yields, falling as they rise. In other words, lower returns on equities this year have been driven almost entirely by cheaper valuations, which in turn have been led by higher discount rates (or bond yields). Losses would have been deeper still were it not for the lofty earnings expectations that remain for the next 12 to 24 months.
This is problematic in two ways. First, while stocks are cheaper than they were at the start of the year, valuations remain above average and richer than the median of the past 15 or so years. There are a handful of exceptions, including China and Japan. But equities are not ubiquitously cheap, and have turned more expensive since the low point in June.
The second question is whether companies can deliver the double-digit earnings expected in a more challenged macro setting, with slowing growth and rising inflation baking in a (mild) recession around the middle of 2023. This is particularly the case in Europe, where aggregated bottom-up analyst estimates for earnings are more than twice what we expect. Cheapness in European equities appears illusory, and this remains our chief “disliked” region globally.
It is also worth noting that not all fixed-income assets are created equal. We have built decent exposures to European investment grade credit this summer, where spreads continue to compensate investors for high levels of defaults. The spreads are close to those of the 2020 crisis for the best-rated European corporates, with an implied default rate of about 9 per cent, twice the worst five-year rate and eight times the average.
Yet, unusually for this point in the cycle, leverage ratios of these companies are contained and falling, interest coverage is elevated and corporate balance sheets are firm. This means the pressure to delever, which usually tends to dent credit as economic cycles weaken, is conspicuously absent as companies enter a potential recession long on cash and maturities.
Every risk has a price — and higher-grade European corporate bonds look attractive to us right now. Ditto commodities. At some point, both sovereign bonds and equities will also look appealing once again — and with current heightened volatility in both the macro outlook and asset prices, we are constantly reassessing our medium-term outlook. But with what we know today, we would need to see much higher yields in bonds, and more attractive equity valuations with less optimism in earnings expectations, to be tempted by them.