Asset Allocation: Fading the ‘Fed Model’

Summary

• We reduce our max overweight position in cash as the forward outlook requires a less defensive posture.
• Within equities, we shift from underweight to neutral on the US. Forward EPS momentum is now positive, fewer sectors are expected to see EPS declines next year, and we see the Fed hiking no more than twice this year – too little to weaken the economy.
• Consistent with a less defensive posture, we shift to neutral on high-yield from underweight.
• We turn overweight on US bank IG credit given spreads are still discounting banking stress. Within IG, we favour a shorter duration.

Our Investment Views by Asset Class

Re-assessing the Attractiveness of Equities Versus Bonds

Following the sharp rise in bond yields over the last 12 months, we assess the relative attractiveness of bonds versus stocks. We do this by calculating the equity risk premium (ERP): the additional return over the risk-free rate required by investors for investing in equities. The ERP is a useful metric over a longer horizon but less effective over a 1-6 month timeframe.

Our proxy for the risk-free rate is the 10-year treasury yield, as it matches the holding period for equities and minimizes the reinvestment risk of shorter-duration treasuries.

The simplest way of calculating the ERP is via the ‘Fed model’. The Fed model uses the inverse of the price-to-earnings ratio, i.e., the earnings yield, as a proxy for the return earned by holding equities, then subtracts the 10Y treasury yield to calculate the equity risk premium.

Currently, this measure provides an earnings yield of 5.0%. This compares to a 10Y treasury yield of 3.8%, giving us an ERP of 1.2%.

The Fed model shows that equities are currently the least attractive relative to bonds since 2003. This suggests investors who can switch allocations between stocks and bonds should consider being underweight US stocks (Chart 1).

However, the Fed model’s methodology has several issues:

• It assumes inflation impacts stocks and bonds equally. However, we know this is untrue. Inflation impacts bonds negatively. But for stocks, it is more mixed and depends both on the volatility of inflation and its impact on corporate profit margins. Therefore, when bond yields rise to compensate for an increase in inflation expectations, the equity risk premium need not rise commensurately.

• It considers the earnings yield as comparable to bond yields for investors. However, the true cash flow received by equity investors is the shareholder yield: dividends plus buybacks.

• It assumes growth in earnings is stable. In reality, earnings growth expectations vary significantly over a 1-, 3-, and 5-year horizon. However, the Fed model assumes that ROE = required returns at all times.

Professor Damodaran of NYU Stern has corrected for these assumptions via his ‘implied equity risk premium’ (IERP) methodology. In sum, his approach assumes the following:

• EPS will grow by analyst forecasts over the next 5 years, after which the growth rate will equal the US 10Y treasury yield (inflation plus real growth).

• Equity investors receive both dividends and buybacks out of earnings. Looking forward, the payout ratio will equal roughly 80% of total earnings (historically sustainable average).

The IERP currently sits at 5% – a different picture of the current attractiveness of stocks versus bonds than the Fed model’s ERP. The median value for the IERP over the last 10 years was 5.4%, with the lowest reading being 3.9% in July 2021 (Chart 2). Accordingly, equities look slightly less attractive versus the median over the last 10 years, but not materially so.

Notably, the IERP also corrects for the Fed model, which showed a negative ERP for much of 1980-2000s.

We can also assess the attractiveness of stocks relative to IG corporate bonds using the ratio of the ERP and IG corporate credit spreads. We find the approach to calculating the ERP materially impacts the conclusion (Chart 3).

• The Fed model / IG corporate credit ratio is currently at multi-decade lows, implying IG credit looks extremely attractive relative to stocks.

• Yet the implied ERP/ IG credit ratio is currently at its median reading over the last 10 years, suggesting they are near fair value.

Given where IG credit spreads are currently trading, we find the latter explanation more consistent.

We continue to think US equities look reasonable versus US bonds rather than expensive as implied by the Fed model, which suggests the ERP is approaching zero. Relative to US corporate bonds, we think equities look fairly valued.

Given Low EPS Growth Forecasts, Why Are Markets Up?

Part of the reason the IERP looks low is that analysts are currently bearish in their forecasts for one- and three-year earnings forward growth for the S&P 500 (Chart 4).

Earnings are expected to contract slightly over the next 12 months, driven by the energy (base effects from high oil prices of last year) and real estate sectors. Communications and consumer discretionary are expected to see the most earnings growth.

Over a three-year horizon, analysts are expecting S&P 500 earnings to grow by just 6.3% annualised, which is in the bottom 15% percentile of readings since 2006.

So given this bearishness, why is the equity market up? We see things improving beneath the surface. We highlight three points below.

1. The number of S&P sectors expected to see lower earnings next year has fallen. Currently, four sectors are expected to see negative earnings growth next year, down from seven in January (Chart 5).
2. Most S&P sectors see rising forward EPS expectations versus three months ago. Currently, 80% of S&P sectors see forward EPS forecasts revised higher versus just 18% in November 2022, meaning forward breadth is improving (Chart 6).
3. SPX forward earnings momentum is improving. Despite forecasts of negative EPS growth expectations over the next year, the forward momentum for EPS on a three-month basis is rising. Forward EPS momentum bottomed in January this year, with forward EPS growth expectations falling from $231/share in September to $216/share in January. Since then, expectations for forward earnings have risen to $222/share at the end of June (Chart 7).

Given these three points and our expectation that the Fed will only hike a further two times this year, we find enough evidence to shift from underweight to neutral on US equities. We maintain our bias toward Quality.

Our Core Investment Themes

Our investment themes remain unchanged and continue to drive our core views. These are:

• The Economy Remains Stuck in a High Inflation Regime.

• Terminal FFR Moving Much Higher.

• Large Fiscal and Strong Consumption Keeps Growth Surprising to the Upside.

What Is the Consensus Asset Allocation?

US equities remains a consensus underweight position with only one manager selecting an overweight position. Meanwhile, overweight EM equities have risen in popularity. Invesco recently shifted to overweight for Q3 due to their bullish view on China, and negative bias on the dollar. Fidelity moves to neutral on cash as they see reinvestment risk rising as the Fed approaches the end of its hiking cycle. Finally, JPM likes short-duration corporate bonds due to the attractive yield ­– we agree. 

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Viresh Kanabar has worked in the UK financial services industry for over 8 years including in Consulting and Investment Risk. Most recently he launched The Macro Journal Substack where he puts out regular in-depth reports covering all areas of global macro.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)