The Great Switchback and the ERP?

March 19, 2012

The risk of a whiplash-inducing switchback from core AAA bonds to equity and risk — now that euro/banking systemic fears have eased and a global economic stabilisation seems to be underway — is suddenly top of most investors’ agendas.  Last week’s surge in U.S. Treasury, German bund and British gilt yields as global stocks caught a fresh updraft saw U.S. equity outperform bonds by almost 5 percent, according to Societe Generale. While not historically shocking in itself, SG reckons the cumulative weight of several weeks of this may well be having its impact on asset managers as the Q1 comes to an end.

Coming on the back on several weeks of equity outperformance, those remaining overweight bonds will be finding life particularly uncomfortable right now.

The question for most strategists is whether this is start of a wholesale rebasing of portfolios that could see dramatic asset allocation shifts over the coming quarters.

Deutsche Bank equity strategists said they reckon 10-year U.S. Treasury yields could “easily” rise another 45bp to 2.70% over the remainder of the year if expectations for policy rates remain unchanged. Its “ready reckoner” suggests such a rise in bond yields would take 3% off equities, all else being equal. However, they stress that if this is in tandem with rising growth expectations, the negative impact on equity could be more than offset.

But Goldman Sachs Asset Management Chairman Jim O’Neill told clients at the weekend that his long-standing bullish view on equities remains rooted in the extremely high global Equity Risk Premium — which measures the global trend growth rate (a proxy for long-term earnings growth) plus dividend yields minus real government bond yields.  O’Neill said that despite a slowdown in the big emerging markets this year, most investors did not take account of the fact that the long-term global trend growth rate was still rising and was now about 4.2%. Real bond yields, meantime, were extraordinarily depressed by a host of policy actions and systemic fears.

Until both the consensus forecast of world GDP growth moves above 4.2 pct, and real bond yields rise a lot, then the ERP offers equity investors a great return. Simple, eh?























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