Asset Allocation in Times of Inflation
I’ve decided to restart blogging and jotting down my thoughts on weekends as it helps me clarify my thoughts. I hope to keep this up on a weekly or bi-weekly basis, we’ll see. For now, until I have a better feeling for what I want to focus on, please just treat these posts as ramblings on a notepad.
These are complicated times where its difficult to form a view more than a few weeks out. Markets are range bound, bouncing between inflation fears and recession fears.
Excess savings buffers built up in the years since the pandemic along with fairly expansive government deficits are preventing a recession, at the same time inflation and inflation fears are driving rates higher and keeping a higher for longer narrative alive, supporting flows from equity into rates and IG.
We haven’t seen this kind of environment in 50 years, hence any longer terms ideas are difficult to find conviction as every investment is right now an inflation derivative and will therefore move (a lot) with the next CPI print (and other inflation proxies) and the next jobs print (and other recession proxies)
The conservative option in this environment is of course to buy 6 month T-Bills, collect 4.9-5% and sit back. Alternative expressions of this are long mid duration IG, and anything up to 5 years in treasuries.
Most recently we have shifted heavily from a narrative of “inflation is transitory, buy growth”, back to a “higher for longer” narrative off the back of stronger inflation, better job markets data, higher growth.
In equities, S&P (quality) and Nasdaq (growth) have been correlated with the strength of the “inflation is transitory” narrative while value stocks and Europe have been correlated with the “higher for longer narrative”. The relative safety and cheapness of the latter has driven a 50% rerating of Eurostoxx since October 12th vs just +13% in the SPX. Now the relative risk/reward looks much more balanced with Eurostoxx having rerated back to their long-term average of 12x NTM EPS and the S&P slightly above (16.7x vs a LT average of 15x NTM EPS). On the margin would still favor the former over the latter with PMI’s rebounding but this is no longer a fresh trade.
Small Bonus:
The above compares the yield on generic BBB corporate bonds to the earnings yield available on equities (hat tip to
for first publishing this methodology).The above implies that the forward earnings yield premium of the S&P over BBB USD bonds is near zero (near historic lows, both around 5.5%). Similarly, this shows that European equities offer a roughly 4% earnings yield premium over BBB EUR bonds (8.3% vs 4.3%) but similarly this number is near the 2009 lows. Just so we have a comparison, the 2009 earnings yield for SPX was around 8.75% (fwd PE of 12x) while the BBB yield was also 8.75%. For Eurostoxx the forward earnings yield was 8.7% (about 11.8x fwd PE) versus 4.2% on EUR BBBs.
One quick note on a deficiency of this methodology: It doesn’t take into account growth expectations where the earnings of stocks can grow (and potentially protect their owners against inflation to the extent capitalists are able to raise their prices faster than their wages) while the return of fixed income is, well … fixed. Current consensus has S&P EPS growing 9% in 2024 while Eurostoxx is expected to grow 6%. We can debate separately whether these estimates are worth anything, but over time this earnings growth is still worth something which is why you will see equities outperform credit over longer timeframes (apparently longer than 5 years?) even when their starting “yields” are identical.
In the US case BBB corporates ever so slightly underperformed the SPX over the next 5 years (66% vs 74% total return, but with muss less vol). In Europe, BBB’s outperformed (29% 5-year total return vs 4% on Eurostoxx). Its unclear that history repeat to this extent, and it would definitely be worth digging out more examples, but it does highlight (once again) that fixed income has become very attractive (think 99th percentile attractive!) on a relative basis to stocks for the first time in 14 years.
Many asset allocators seem to be grasping that at this point this is the easier and safer bet relative to equities (or even the long-short equity game) and that the higher Sharpe ratio bet may lie in bonds.