As investors pile into expensive equities and shun government bonds, John Stopford, Head of Managed Income, questions whether market complacency is obscuring one of the more compelling opportunities in fixed income for years.
Investors have rarely been more enthusiastic about equities, or more sceptical about government bonds. US households now hold a greater proportion of their financial assets in equities than at any point in recorded history,1 while government bond yields are at levels seldom seen over the past 25 years. Yet enthusiasm for fixed income remains subdued.
This contrast raises an important question: have investors become so conditioned by recent market performance that they are overlooking where more attractive opportunities may lie?
Market participants often exhibit what are termed ‘adaptive expectations’ and ‘recency bias’ in how they invest. In other words, their behaviour tends to be conditioned by what they have experienced, with more significance given to events that are fresher in the memory.
Investors appear to expect the strong performance delivered by the stock market in recent years to be replicated into the future. History suggests, however, that equity returns tend to mean revert, with a greater likelihood of disappointing performance in subsequent years after a prolonged run-up in prices.
John Stopford, Head of Managed Income: "The danger isn't simply that investors expect equity markets to keep rising. It's that years of strong returns have encouraged a level of complacency that leaves little room for disappointment. History suggests that when everyone is betting on the same outcome, the risks can be greatest.”
Recency bias also shows up in analysts’ economic and earnings forecasts, which tend to anchor to recent outcomes. Anchoring is similarly visible in corporate bond spreads and equity implied volatility. Both spike during a major market event, then tend to make a series of lower highs and lower lows over several years until the next crisis, when the cycle begins again.
For long periods, recency bias isn’t a problem. As the saying goes, ‘the trend is your friend’. Over time, however, it inevitably leads to complacency, herding and capital misallocation. In 1998, Paul McCulley coined the term ‘Minsky moment,’ after the economist Hyman Minsky, to describe how long periods of steady market gains tend to end in severe instability and losses once the dynamics behind the rally run out of steam.
Stopford: “Today we live in what seems to be a fairly complacent world in which a large proportion of the world’s savings are held in just a small number of stocks driven by a narrow set of themes. Maybe Buzz Lightyear’s cry of ‘to infinity and beyond’ will be realised this time, but history suggests that a rational investor shouldn’t bet on it.”
Which brings us to the government bond market.
Just as it is hard to find many equity bears at present, it is equally hard to find many bond market bulls. Yet, with medium-dated bond yields at levels not seen for much of the last 25 years, prospective returns look reasonably attractive.
Stopford: "Investors are struggling to find reasons to own government bonds, even as yields offer prospective returns not seen for much of the past 25 years. The pessimism towards bonds looks increasingly difficult to justify."
The 40-year bull market that began in 1981 appears to have ended with the pandemic, government borrowing looks excessive, and inflation has proved more persistent. Even so, bond markets exhibit adaptive expectations, meaning they adjust to new information gradually rather than all at once.
Over the last 65 years or so, bond yields have tended to move up and down in waves over time. These swings can be largely explained by evolving trends in growth, inflation and official interest rates. Even in the late 1960s and through the 1970s, yields adapted only slowly to the sharp rises in inflation and interest rates, taking more than 16 years for 10-year maturity US Treasury yields to increase from around 4% to a peak of close to 16%2.
At current yields, most major government bond markets appear to have already adapted to the increases in government borrowing, inflation, growth and interest rates we have latterly experienced. Even if these trends continue, the new reality looks priced in at current yields, and for the first time in a while, owning bond duration outright or as a hedge against expensive equities looks quite compelling.
Stopford: "Bond markets have already adjusted to much of the bad news on inflation, interest rates and government borrowing. At current yields, that new reality looks well priced in. For the first time in a while, we believe owning bond duration looks compelling, both outright and as a hedge against expensive equities.”
1. Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Financial Assets; Assets, Level (BOGZ1FL153064486Q) | FRED | St. Louis Fed
2. Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis (DGS10) | FRED | St. Louis Fed