In very generic terms, there are essentially three different asset classifications. There is cash, debt and equity. There are varying structures and even some hybrid structures that have attributes of debt and equity, but these are the main broad classification.
For a person who has excess cash that they do not plan on spending for some time, these are the main options in which to store or invest the money that can be quickly and cheaply liquidated if needed.
Due to the relationship between the classes, there becomes a tug of war between these competing assets for investment capital. Financial and economic theory would dictate that bond rates and equity risk premiums adjust over the short to intermediate term to provide comparable risk adjusted returns to cash. If we use June 1 as the starting point, investors would see that cash is yielding less than 0.25 percent, 10-Year Treasuries are yielding 2.53 percent, and lastly the earning yields (earnings/price) on stocks, as measured by the Dow Jones Industrial Average, is approximately 6.38 percent. With the difference in yield between the different asset classes, it is no wonder that money has been flowing steadily into the stock market over the past five years.
Sometimes, these dynamics can be upset, such as during the late 1990s to early 2000s when the Federal Funds rate was 6.5 percent. which closely matched cash interest rates. At the same time, 10-Year Treasury yields were approximately 6.2 percent, which indicated that the expectation was that the Federal Reserve would most likely be lowering interest rates in the coming years or that they were temporarily inflated. Stock yields as measured by the Dow 30 earnings yield were 4.35 percent and even worse, the Nasdaq Composite Index had an earnings yield of less than 1 percent. It could have been inferred that risky assets such as stocks were yielding significantly less than conservative assets such as cash and bonds.
Why were the yields so inverted to the level of risk? The main reason is expectation. Years 1999-2000 were the height of the dot.com bubble and the expectation was that stocks, especially technology stocks, were going to continue to soar and nothing could stop them. A comment that was made during this time was that tech stocks were recession proof due to their capital structure of high equity and low debt. It became imperatively clear that was not the case by the end of the year.
As we started to enter a recession, many people stopped or reduced their online purchases. Also, companies that were never going to be viable closed very quickly. As for the wider market, investors witnessed the Dow 30 decline in value, which increased the earnings yield. At the same time, the federal funds and 10-Year Treasury also substantially declined, putting the market back in equilibrium.
Even though the current yield difference between cash, bonds and equity seems reasonable to expectations, what is the outlook for the market going forward? One of the best places to start is to look at the Federal Reserve Board minutes. The last set of board minutes was released in March. It appears the Federal Open Market Committee (FOMC) participants judge that, absent any further shocks to the economy, the first increase in the federal funds rate, which is closely tied to interest rates on cash, is projected to be around 1 percent by the end of 2015. By the end of 2016, the average participant’s estimate was that the federal funds rate would approach close to 2 percent. In the longer run of five to six years, they estimated the federal funds rate would rest closer to 3.5 percent to 4 percent.
If interest rates on cash were to adjust to 3.5 percent to 4 percent, then yields on bonds and stocks would also follow suit over the intermediate term. If the expectation was the federal funds rate would remain close to 3.5 percent to 4 percent and there was no signs of the economy needing more stimulation or that it would be overheated, an investor could expect 10-year bond yields to be around 4.25 percent to 5 percent. Rising rates could be a headwind for the longer duration bonds market performance.
As for equities, it will take at least several years for the fixed income market to readjust to higher rates, which will be very positive for the equity markets in the meantime. Once cash is yielding between 3.5 percent and 4 percent, it could be assumed that the earnings yield on stocks will increase to 7 percent to 9 percent based on historical spreads.
The increase in equity yields can be achieved in three different ways. Earnings of corporations could increase, the price of securities could decrease, or a combination of both. The FOMC is projecting that GDP will increase to 1.8 percent to 2.4 percent over the long term, so it is assumed that earnings for corporations on aggregate will also increase by a similar amount. This will increase the earnings side. If stocks returns start leveling off to 3 percent to 7 percent returns on average, then it could be a gradual adjustment to a higher earnings yield for the equity market.
Although there may be some pullbacks in the market, barring any major crisis or shocks, the short to intermediate prospects of equity performance still look encouraging when compared to cash and long-bond yields.
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.