- Goldman Sachs’ portfolio strategy managing director advises shifting from credit to equity.
- He notes tight credit spreads, peak-growth momentum, and continued upward pressure on bond yields.
- “As we are heading into midcycle, equities are likely to outperform.”
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The recovery in risky assets after the COVID-19 crisis, boosted by monetary and fiscal stimulus and the development of a vaccine, has been remarkable.
Both equities and credit posted a much stronger rebound than after most historical bear markets, on a par with the recoveries after the 2007-08 financial crisis and the Great Depression.
Large increases in valuations have driven material capital gains, which is common during the early stages of a. But as global momentum peaks, returns and valuation expansion for risky assets are likely to slow, and income, or so-called carry, will become more important relative to capital gains.
Moreover, structural demand for income remains strong — considering low real yields, an aging population, and potential increases in capital-gains taxes.
Even after the bond sell-off that began last year, the opportunity set for generating income in fixed-income markets is limited, and investors are forced up the risk curve.
But the yields on US high-yield bonds are also hovering around all-time lows: In fact, still roughly 20% of global (mostly sovereign) bonds offer a negative yield, and that is before inflation, which can further erode real value.
Corporate credit spreads are close to all-time lows and have been unusually resilient despite elevated equity volatility in the year to date.
Credit often lags equities during “risk-off” periods, at least initially, but the sensitivity to equity swings has been particularly low recently due to central-bank support for credit and because equity volatility owed more to rate shocks than to growth concerns.
Last year, falling bond yields boosted secular-growth stocks, but rising yields have weighed on them since then.
Such low-credit spreads don’t leave much of a buffer for potential negative-growth shocks or for rising yields. In fact, high-quality US corporate bonds have already posted their worst year-to-date performance since 1997.
Duration is high and has, in many cases, increased in fixed-income markets with low yields and corporates issuing longer-dated bonds. An increase of just 25 basis points in 10-year bond yields erodes one year’s worth of yield from a US investment-grade credit index.
Furthermore, bond yields could see more upside risk this cycle: Lingering deflation concerns dominated the last cycle, owing to the depth of theand second-round effects from the 2007-08 financial crisis, whereas this one began with more inflation optimism due to a reflationary policy mix and less deleveraging pressure.
In the medium term, equities are likely to digest rising bond yields better than credit. In many cases, equities can provide an inflation hedge, at least in the long run.
Given tight credit spreads, peak-growth momentum and continued upward pressure on bond yields, we would shift from credit to equity in portfolios.
Credit tends to perform best early in the cycle, with credit spreads tightening sharply as investors fade recession risk and bond yields are anchored.
By contrast, as we are heading into midcycle, equities are likely to outperform with credit spreads already tight, central-bank support easing, growing earnings and potential for a pickup in corporate releveraging.
Of course, high-dividend yields do not automatically mean equity-high returns. In some cases, higher income has meant lower total returns in the long run.
For example, despite much lower-dividend yields, US equities outperformed Europe materially last cycle, supported by both rising valuations and earnings growth.
During the last cycle and the COVID-19 crisis, higher-yield stocks often lagged the market.
Investors need to balance the growth-yield trade-off in equities, as higher-dividend yields often indicate poor growth prospects. In simple terms, investors are demanding a higher yield upfront to compensate for lower potential capital gains.
If companies are paying out more earnings and reinvesting less, that often means lower growth and possibly higher leverage.
Last cycle, many high-stocks, such as banks and those in commodities-related sectors, turned out to be value traps, while secular-growth companies that had attractive long-term prospects were in demand, given concerns over secular stagnation and the boost from falling bond yields.
High-dividend-yield stocks now look more attractive, especially relative to credit.
In many cases, a weaker growth outlook for higher-yielding sectors is already discounted, and some of last cycle’s headwinds might ease from here.
With a more reflationary policy mix and the strong recovery from the COVID-19 crisis, some high-dividend-yield stocks such as energy and banks offer valuable optionality on rising growth and inflation.
More defensive parts of the market such as staples and healthcare also offer attractive yields versus credit, while being less of a bet on reflation.
Christian Mueller-Glissmann is the managing director of portfolio strategy at Goldman Sachs