Out of equities into bonds: is there a better option?

Though we have the occasional respite in global equity markets, the long-term prognosis still looks grim.

Valuations look stretched and if one adjusts core earnings for un-funded pension liabilities and for executive options - an adjustment of a further 40% in the case of the S&P500 - valuations look even more unrealistic, with p/e ratios above 50 for the S&P500, four times the historical fair value.

On the positive side, by the second quarter we could see signs of investment-led growth, but even with the most optimistic assumptions of performance one is struggling to reach beyond 5% or 6% dividend yield on US equities.

The picture looks a little better in European equity markets, though weakness in the US stock market can be expected to drive sentiment there too.

In contrast, and in large part due to large allocations to domestic equities, pension funds both sides of the Atlantic are seriously under-funded and many require an 8% or 9% return in the future to meet actuarial liabilities. The optimists, of whom there appear to be plenty, may invoke tactical logic for remaining in equities for now.

If equities do well in 2003 it will indeed most likely be due to portfolio rebalancing (by which under-performing asset classes like equities are the recipients of new inflows from pension funds so that their target allocations are maintained) and/or due to the seeming lack of alternative homes for funds to go to. Both are short-term and negative motivations, but what are the alternatives?

Then again, why should optimism over equities be seen as short-term and negative? Rebalancing is justified in mean-reverting markets. The reason is we may now be in a secular bear market. To determine whether this is the case and hence whether optimism may be justified after all, we should consider not only current valuations, but also the history of financial markets and secular trends.

Equities were not always king - bond markets developed first and were more dominant even for retail investors for centuries until the second half of the 20th century. The equity premium is not written in stone, and there have been many periods when bonds have for long periods outperformed equities.

Moreover, there appears to be a theoretical as well as empirical relationship on the one hand between fixed exchange rates and low inflation/deflation with bond out-performance, and on the other hand between floating rates, inflation and equity out-performance.

The picture going forward is not clear, because we still have floating exchange rates (although not inside the Eurozone), but we do seem to be in a world of low inflation now. Hence many are questioning the ability of equities to outperform bonds over the next ten years and more.

The consequence is a thorough review of allocation weights. If one believes debt may outperform equity then this would justify a 60-70% weighting in bonds and 30-40% in equities, not the other way round as at present. The fact that allocations only move slowly and gradually (because decisions are intermittent and staggered across the industry) means such an adjustment may take a long time. In the meantime, money may be slowly pulled away from equities, potentially capping upside for years.

However, G7 government bonds do not look particularly attractive either. Global interest rates are low and expected to turn up at some point, even if this now may have to wait until next year. G7 bonds are not going to reach that 8% or 9% actuarial return either, even if they are relatively attractive compared to equities and not expected to lead to further major losses. Hence, not only is there likely to be a net shift into fixed income: there is also likely to be within fixed income a shift towards higher yielding and diversifying assets.

Why the higher yielding assets are to be favoured should be clear from what we have already said and from the observation that, for example, 10-year government bond yields are under 4% in the US and under 1% in Japan. However, diversification is also crucial.

Take for example emerging market debt as a potential asset class to diversify into. Firstly, the returns are strong with reasonable levels of risk. Secondly, it has negative correlations to US Treasuries and other G7 government bonds and is counter-cyclical to the G7 business cycle.

Looking at these characteristics more closely - firstly good returns with reasonable risk - the ten-year gross return of Ashmore's flagship fund as an example is above 25% per annum, and the monthly volatility of index returns has reduced substantially since 1998 and is now, at around 8%, half that of the S&P500.

Also, though a country defaulting hits the headlines, default risk is historically around 0.5% per annum or about one tenth that of comparably rated High Yield bonds - i.e. this risk is not as high as often perceived. There need not be any currency risk, either, as bonds are denominated in dollars or Euros. Also, the market has matured since the mid-90s, and now has a more mature investor base (institutional investors not hedge funds).

Since 1998 and the reduction of leverage in the market and move from fixed to floating exchange rates, financial contagion from one emerging market country to another the other side of the world has disappeared. The remaining form of contagion is that which affects all markets: where contagion originates in the US or G7, as exemplified by contagion from the US to Brazil last year as US banks withdrew credit due to problems at home.

Secondly, there are diversification benefits from emerging debt being counter-cyclical to the business cycle: the global reduction in interest rates accompanying economic slowdown reduces debt service costs for countries, increasing creditworthiness.

This is more dominant than any business cycle effects. This is in part because emerging debt is a liquid market driven by rapidly changing fundamentals with most value from investment strategies achievable within a year (another feature of which is that specialist active management can deliver strong and consistent out-performance). Hence the multi-year impact of recession or global slowdown are less important as determinants of investment return than short and medium term factors - including reduced interest rates.

Likewise emerging debt is counter-cyclical to any global recession induced by high oil prices due to a number of significant oil producing countries in the asset class.

Hence not just the diversification benefits of emerging debt are attractive, but so is the ability to protect a pension fund portfolio from a number of negative scenarios - for example an oil price shock induced by an escalation in the Middle East. It is noteworthy that of all major credit markets emerging debt was least damaged by 9/11.

Typically putting emerging debt into a portfolio both reduces volatility and increases return, but what is the exception? An analysis of negative months in the Lehman Aggregate highlights five periods when there have been sustained losses over the last ten years, and in four of these emerging debt has delivered a positive return.

The exception was in 1994, when severe Fed. tightening was also combined with growing problems in Mexico, culminating just after the period with devaluation in December 1994. Hence it is in a scenario of a major series of interest rates increases that emerging debt may not help. In all other scenarios, including that of gradually rising interest rates (which tends to be associated with an increase in risk appetite), an allocation to emerging debt seems to reduce risk.

For these various diversification and risk scenario reasons allocations to emerging market debt are increasing. However, emerging debt is just one example of an attractive asset class increasingly being sought out.

Its characteristics are not particularly new, but the motivation to overcome prejudices and invest in such an asset class are now greater than when global equities performed well and pension funds were better funded. It is to similar high yielding diversifying asset classes that pension funds must increasingly look in order to cope with the secular bear market in equities and high target rates of return.