During the so-called great disruption to the investment framework, that occurred after negative rates were introduced, investors found themselves at sea and with no north star to guide them. And with good reason: how can you assess the value of and return on financial assets when they can only compare them to zero or negative rate risk-free assets? Having negative rates on 10-year bonds versus a zero-rate on deposits was just as unsettling.
Suddenly leaving this framework behind means returning to a more normal financial order. One manifestation of this return to normal is the return of time value of money, which remains the basis for any bond investment or loan relationship. What is the rationale in macroeconomic theory for the existence of a return associated with a loan or an investment? The preference for the present, i.e. the capacity to consume now and not later (savings are deferred consumption, and the interest rate is in some way the cost of sacrificing immediate enjoyment).
It is therefore a very good thing that deposits and bond investments are once again bearing yield. First, because it might help lower consumption and investment and reduce inflationary pressures. Second, because it reintroduces healthier trade-offs between consumption and savings, but also between asset classes.
Even though time value’s comeback remains unfinished (as seen in the inverted yield curves in this monetary adjustment and slowdown phase), it signals a more balanced relationship between savers and borrowers, and makes savings meaningful again… as long as the more persistent-than-expected inflation can be beat. It is starting to show signs of stabilising in Europe and of slowly easing in the United States. This explains the heightened focus on return for all asset classes, setting aside hopes of an increase in the indices.
If time finds new value, then investors have less need to sacrifice liquidity or portfolio quality in order to achieve returns. The other implication of this disruption is the death of TINA (the famous “there is no alternative” to equities) which was still heralded only a couple months ago. First, because the rise in rates has been adversely affecting the present value of future cash flows for a year (another sign that time value is making a comeback). Second, because the return of bond yields may bring the weight of equities to its fair value in a portfolio. Yield is in fact very close to the ratio of net income to share price for US equities. We therefore need further confirmation of attractive growth outlooks and/or a high and growing dividends (or a more significant correction in valuations) before we can justify a high weighting of equities alongside high-quality corporate bonds that are already offering returns.
In 2023, we will likely see the return of the “60/40” portfolio, whose definitive and long term demise we had been a bit too quick to announce. Bonds should therefore return to portfolios in early 2023, before improved earnings and the likely easing of monetary policies provide a long term boost to the equity market in the second half of 2023. Furthermore, as markets will not wait for confirmation from the US Federal Reserve (Fed) to make their judgement, any signs of a fall in inflation should translate into a rebound in equity markets. Only time will tell whether the rise in markets that followed October’s inflation was justified but, in our view, it is still too soon to bet on a Fed pivot at the end of the year.
Monthly House View, 18/11/2022 release - Excerpt of the Editorial
November 25, 2022