When future history books will describe the economic developments of the last ten years, they will have to talk about a veritable revolution in the financial world.
The great financial crisis which erupted as a subprime debt crisis in the United States served as catalyst for the ensuing radical changes. The main financial asset class of the world – bonds – is almost headed for extinction unless the Savers of the world are willing to accept ultra low real interest rates for longer periods to come. Given the needs for financial returns within the aging populations of most of the developed parts of the world, such a scenario is unlikely because it is uneconomic. Indeed, the demographic challenges of most western countries as well as China will be the dominant obstacle to economic growth in the decades to come.
An economic troika consisting of highly indebted countries, ultra low interest rates and aging populations makes the shift out of bonds to higher returning assets inevitable. What has been called the great rotation is now slowly getting under way and perhaps gathering speed. But as long as bond markets remain in their super bull cycle, the shift towards equities will continue to be gradual. We shouldn’t forget that government bonds are enjoying yet another great year with stellar performance, albeit the main driver of its total return in fixed income is not coupon based, but rather solely price change derived.
The equity markets which have rallied alongside the bond markets for years seem to be ready to finally decouple from the bond wagon. Mainly driven by flow of funds, the equity markets have a lot more room to blossom if the interest rate picture remains benign. On an absolute valuation basis equities are quite expansive. When historical measures are taken into account, most stocks are clearly overvalued. Indicators such as private equity activity and takeover frenzy and lofty IPO´s further support this view. The picture looks quite different from a relative perspective. Vis a vis other financial asset classes, equities are actually somewhat cheap. Given that the main longer-term competitor to stocks are bonds with longer maturities stocks show up as attractive.
Take the Swiss and the German market as a case in point:
Swiss government bonds with a ten year maturity yield minus 0.4% and German Bonds yield a positive 0,1%. It is no coincidence that the latter were just named the “short of a century” by a well known bond fund manager. In the end, it all depends on whether we live in a regime of new normality since the great crisis or if we will be experiencing a reversion to historic means. A return to historic normality would imply a bond crash which is definitely not in the interest of the central banks of the world. It is far more likely that the future main goal of the Fed, the ECB and the Bank of Japan is to prevent such a scenario. At this point, I favor the view that markets in the next years, will not return to where they used to operate. Hence, equities remain unrivalled and the structural revolution towards higher equity holdings by institutional and private investors will continue.
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