A common theme when talking to clients is: Where can we find returns going forward? With historically low interest rates working their way through bond markets, yields from governments to high yield are unattractive.
We always say we don't mind taking on risk as long as we get paid for it, and with the low absolute level of rates these days, the expected reward often isn't worth the risk. The common consideration is that bonds offer stable returns, low risk and low volatility. However, when you look at absolute yield levels (especially considering taxes, fees and trading costs), the return isn't there to justify much risk at all. Also, considering the lack of transparency and illiquidity in the bond market, I would say that volatility in corporate bonds is understated. (A quick Bloomberg search found only 36 issues with yields above 5% that are actively priced in Canada!)
Over the last six years, the yield on the U.S. high-yield index (ticker: JNK) has been cut in half. Over the same period, the P/E multiple on the S&P 500 has been relatively stable, with the forward multiple now at 16x. In fact, the current return potential on U.S. stocks is second only to housing, as can be seen on this chart:
Source: RBC CM Quantitative Research
While we are always very pragmatic when investing, this chart suggests a potentially very bullish scenario: Where would equity valuations go if the extended valuation seen in bonds worked its way into the equity markets? Would we see a P/E of 20x?
We have seen bond managers begin making allocations into equities, and the multiples of defensive names have expanded (see chart below), but not the multiple of the market as a whole. Therefore, with the current macro backdrop in North America and the fact that the non-defensive names remain cheap, we continue to favour U.S. domestically focused cyclicals and growth (tech) names as offering the best risk-reward potential today.