Why equity valuations still provide an attractive long-term yield

Portfolio manager says exposure to multiple asset classes is required to capture sensitivities to different macro conditions

Why equity valuations still provide an attractive long-term yield

Investors worried about equity valuations should be calmed by the extended central bank easing cycle, according to a chief economist.

Todd Mattina, SVP, portfolio manager and Team Co-Lead at Mackenzie Investments said that global equities have gained about 45% since their low point on March, with the speed of the rally spooking some investors.

However, he believes that valuations have moved broadly in line with shifting fundamentals and are supported by the fact cash yields are expected to remain at about zero for an extended period, meaning equities provide an attractive long-term yield with the caveat that the pandemic will result in uncertainty around the speed and shape of the economic recovery.

He said: “While the growth trajectory in 2020-21 remains uncertain, the extended central bank easing cycle has increased the long-term equity premium to attractive levels, rewarding investors with a long horizon and tolerance for a potentially bumpy road in the recovery.”

After the worst economic downturn since the 1930s, the aggressive policy response has been key, with central banks slashing policy interest to around zero. Mattina said this has prevented a more severe contraction, allowing credit markets to continue functioning and supporting the rebound in asset prices. He believes that while government bond yields are expected to remain low for a prolonged period, they continue to provide a modest yield premium over low cash rates.

He explained: “Fed policy makers have also provided ‘forward guidance’ to investors that cash yields will likely stay low for an extended period to support the fragile recovery. On top of these cyclical factors, secular forces, including demographic aging and low productivity, will continue to keep downward pressure on long-term bond yields. While investors may not like the low level of cash and bond yields on offer, low rates are likely to persist given current economic conditions. In this context, relative asset yields are the key consideration for long-term asset-mix decisions and the U.S. 10-year Treasury still provides a modest premium over cash yields.”

Meanwhile, gold has surged, topping $2,000 and raising many people’s concerns around higher expected inflation, a debasement of national currencies by money printing and heightened geopolitical risk.

But Mattina said higher gold prices can also be understood based on a framework of relative asset yields and liquidity. He warned that, as gold does not provide a cash flow, holding gold as a long-term asset could be an expensive way to add inflation sensitivity in a portfolio compared to inflation-linked bonds. However, current bond yields after inflation are deeply negative, which reduces the opportunity cost of holding gold versus interest-bearing bonds.

He said: “Also, the weakening U.S. dollar has passed through into higher gold prices. In an era of negative real yields, gold may represent an alternative inflation-sensitive asset. However, the average gold price since 1973 expressed in today’s dollars is about U.S. $930 compared to US $1,975 as of July 31, 2020.Consequently, investors interested in building a long-term strategic gold position should consider dollar cost averaging over time into desired positions.”

Overall, a prolonged period of cash yields at about zero is expected to support equity valuations given relatively attractive yield premiums compared to history. Mattina also expects a prolonged period of “lower for longer” long-term bond yields.

He added: “We recommend that investors and their advisors strive for a well-balanced long-term asset mix to weather different possible economic conditions in the future. A balanced portfolio requires multiple asset classes to capture sensitivities to different macro conditions.

“Traditional stocks and government bonds remain key components of a diversified asset mix. As the Canadian dollar typically under-performs when global equities weaken, maintaining unhedged exposure to US dollar-denominated assets can help to hedge total equity risk in a portfolio.”