Beware the great equity unwind

In 2022, central banks and governments began the ‘great unwind’ — that of the monetary and fiscal variety – as a decade of ultra-low interest rates and Covid-stimulus packages were brought to an abrupt end.

Even so, the most well-telegraphed recession in memory has yet to materialise and equity markets have proven resilient despite the sharpest tightening cycle in 40 years.

In our view, the near-term backdrop for equities remains concerning. Borrowing costs have risen sharply, pandemic savings are forecast to soon disappear and wage pressures continue to build. Moreover, valuations appear stretched particularly when considering yields on risk-free assets.

However, longer-term headwinds could prove just as challenging.

Structural changes afoot

Over the past four decades, companies have benefitted from expanding profit margins; driven by disinflationary tailwinds including globalisation, the removal of trade barriers, the dollar devaluation and a subsequent shrinking of the cost of capital.

Moreover, favourable demographics — across developed market economies and China — assisted corporates in retaining an expanded share of profits.

Burgeoning migrant populations, women entering the workforce and the baby boom provided corporates with a dearth of human capital. Among other factors, this provided companies with sizeable bargaining power.

As a result, in Australia, the share of GDP going to workers is near record lows. In the US, corporate profit margins are again approaching all-time highs and the share of income going to labour has been trending lower since the 1970s — accelerating markedly since 2000.

Now, developed market economies are reaching an inflection point. Total dependency ratios will rise dramatically in the decades ahead and should provide workers with a platform to demand a higher share of profits. The steady rise in populism since the early 2000s is likely to accelerate the process and gather momentum as the next generation of voters — who haven’t benefitted from massive asset appreciation fuelled by low rates over previous decades — demand greater equality. This new cohort of Gen-Z and Millennials are expected to control the popular vote in the US within a decade.

Combined with the potential for structurally higher inflation, a shift towards deglobalisation, rising geopolitical tensions and a scarcity of trust amongst regions, we expect higher volatility, lower profit margins and relatively constrained returns on equity for developed market shareholders over the decade ahead.

Conversely, except for China, human capital is unlikely to be an issue for most emerging economies. This may provide opportunity for better growth outcomes in these regions and further accelerate the transformation from working-class to consumption-led economies.

The unwind

Equities have been the traditional growth driver for portfolio returns; the S&P 500 and ASX 200 providing 30-year annualised returns of 10.5% and 9% respectively. 

However, longer-term, there are signs investors may need to adjust to a new norm. Indeed, the adage “past performance is no guarantee of future performance” could ring true.

Analysis shows the average US investor’s equity allocation is closely related to forward 10-year share returns. Higher exposure to equities correlates with lower future returns. At the end of June last year, the average allocation was roughly 47.5%. Down from peaks of 51.5% in 2000 and 2021, but rising and elevated relative to historical averages.

Average US Investor Equity Allocation and S&P 500 10-yr Forward Returns

Source: Bloomberg, Federal Reserve Bank of St. Louis, ANZ CIO

CAPE Real Yield and S&P 500 10-yr Forward Returns

Source: Bloomberg, ANZ CIO

Compounding this is the likely unwind of equity positions as more Baby Boomers retire. Over the coming decade, we expect a sizeable rotation from equities towards defensive income-producing assets as retirees derisk portfolios.

Moreover, valuations appear stretched by historical standards and the correlation with long-term equity returns also points to more subdued performance over the ensuing decade. While not at 2000 extremes, last year the CAPE real yield hit its lowest point since 2007.

Together with the expected reversal of disinflationary tailwinds, the demographic unwind, and likelihood that government policies may favour labour and wealth redistribution moving forward, the long-term outlook for developed market equities is hardly inspiring.

Technology, and the productivity gains it may provide, remains the unknown. So, while the outlook is opaque, there will of course be sectors and regions that present value.

A fixed income renaissance

Conversely, the medium-term outlook for fixed income (while not structural) appears constructive. Despite the recent bond rally, yields remain relatively attractive from an outright and historical perspective and our analysis suggests that at current levels, longer-term bond returns should be favourable for multi-asset investors.

Modelling shows 10-year government bond yields are a strong precursor to longer-term bond returns. Last year, the yield on the US 10-year Treasury note hit a 16-year peak and Australian 10-year government bond yields reached the highest point in more than a decade.

Yields hold a strong correlation with long-term bond returns

Source: Bloomberg, ANZ CIO

This starting point for yields is important. Our analysis shows, that since the late 1970s, future three-year returns were positive for investors when starting yields were above 2 per cent.

Moreover, while periods of yield curve inversion may seem unfavourable for adding bonds to portfolios, the counterfactual is often true. The recession that typically follows such inversions provides an environment where not only do bonds markedly outperform relative to periods of upward sloping curves, but they also tend to provide excess returns to cash and equities.

The US 2-/10-year yield curve has been inverted since July last year — the longest period since 1980. As we enter a period of expected vulnerability, and with yields at elevated levels, investors have a unique opportunity to build more resilient portfolios by increasing their allocations to fixed income.

Across portfolios, we are tactically positioned with a preference for fixed income assets. As traditional return drivers become challenged and in anticipation of a more volatile chapter for markets, we expect to implement larger structural overweights to emerging market equities and alternative assets in the period ahead.