Equity investors are renowned for their optimism, or what a curmudgeonly bond trader would view as a combination of ignorance and confidence.

Major government bond and equity markets reflect contrasting outlooks for the world economy. The rebound in equities, credit and commodities such as oil, suggests a reassurance that growth will overcome a soft patch and gain altitude later this year.

The message from government bonds is different. With the amount of global negative-yielding debt back above $9tn and at the highest since late 2017, bond investors are less confident that the growth and inflation expectations of leading central banks will materialise.

Given this dissonance between the two major markets, it is understandable that plenty of investors are reluctant to chase this year’s rebound in equities. One important caveat is that money has flowed into China, before and after MSCI added more of the country’s stocks to its flagship emerging market index. China’s ranks of retail bulls have been rewarded by the power of indexing.

Analysts at Société Générale have focused on where money is flowing, and this week note that “equities have risen the most in decades, but outflows from the equities asset class have been significant, caused by last year’s damage to portfolios”.

This chimes with the money leaving US equity exchange traded funds this year, with the latest tally of outflows pegged at $17.6bn, according to XTF.com. That leaves buybacks supporting Wall Street.

The lack of clarity over what a US-China trade deal might look like makes hugging the sidelines even more appealing for investors. For all the optimism suggested by the world-beating performance of Chinese equities this year, there is precious little detail on whether the world’s two biggest economies can settle their differences.

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Indeed, defensive positioning in equities, alongside slumbering bond yields, suggests fund managers are wary that 2020 could prove tough. At the heart of this fear is whether a slowing US economy finally brings the performance of Wall Street stocks back into line with a less spectacular showing from the rest of the world in recent years.

One of the most striking features of the past decade has been the leadership of US stocks, with the S&P 500 eclipsing its global rivals. Using 12-month forward earnings, US equities look expensive versus the rest of the world. The S&P 500 trades at 16.8 times 2019 estimates, while the FTSE All-World index, excluding the US, is at 12 times. It is a gap that has been growing over the past five years, reflecting how the S&P 500 has been turbocharged by tech stocks just as struggling financials hinder other developed and emerging world equity markets.

Given the large presence of banks in the eurozone equity market, for example, it is hardly surprising that investors have shunned the region over the past year. There is little that would encourage investors to wade back into the water given the extended outlook of low government bond yields and a eurozone economy reliant on global demand picking up.

Certainly the Stoxx banks index stands out as a cheap sector judged by its book value. It has not been above 1 since 2007, but that is precisely because the industry is so challenged.

Which brings us to a key question of whether expensive US equities should be shunned in favour of other “cheaper” markets. Another point of comparison between Wall Street and its rivals, including MSCI’s EM index, is their return on assets, and here the S&P 500 had a hefty advantage.

Nicholas Colas at DataTrek reckons US equities justify a higher valuation because the companies have better earnings growth prospects and benefit from “future technological innovation that defends and expands competitive advantage”. One can quibble over whether that justifies the full valuation premium the S&P 500 commands, but Mr Colas holds to a “longstanding recommendation to be overweight US equities in global portfolios”.

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While the US valuation premium sticks out, and rightfully raises fears that Wall Street faces a major reckoning, it needs to be placed in a wider context. The backdrop of low interest rates may well stem the extent of any reversal, allowing equities to eclipse fixed income returns over the coming decade.

As Capital Economics argues: “The real return from US equities in the coming decade could plausibly be less than a third of what it has been in the last 10 years (the average annual real return since 2009 has exceeded 15 per cent)” and still top the returns from other assets, notably Treasury bonds.

Given the low levels of Treasury yields leaves their returns after inflation close to zero, US equity investors may well enjoy the last laugh over both a global stock portfolio and government debt.

michael.mackenzie@ft.com



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