Bilal’s Macroscope – Can Stocks Beat Cash at 5%?
- By Bilal Hafeez
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Summary
- Cash at 5% makes it harder for equities to outperform.
- Leveraged and dividend-offering companies are struggling.
- Investors must focus on excess returns rather than absolute returns, and they show equities have weaker returns since the 1800s.
- On top of that, stocks were supported by big drops in tax rates since the 1950s. That is unlikely to repeat.
We have long argued cash should be preferred over equities in inflationary environments. This may sound odd, but remember that cash outperformed equities in the inflation-prone 1970s. Another way of looking at this is that moving from a risk-friendly regime of low rates/QE regime to a new higher rates regime means more uncertainty, making capital preservation key. Cash offers more capital preservation than equities.
But the larger issue is that cash was only offering yields of around 1% between the GFC and COVID. This was extremely unattractive for investors, who then flocked to equities. Moreover, companies could easily leverage their returns and engage in buybacks. Everything was working to goose equity returns.
This also had the terrible side effect of most investors no longer thinking about excess returns (return of equities minus cash return), but rather absolute returns. Now cash is offering yields of 5%+, meaning equities must gain 5% before beating cash.
This higher rate hurdle means many stocks may struggle to perform. Looking at equity factor returns in 2023, large companies with stable earnings have performed best (Chart 1). Meanwhile, companies with high leverage and dividend yields have struggled. In a world of higher interest rates, both leveraged and dividend-offering stocks become less attractive.
Also, looking at absolute returns gives the illusion that equities always deliver positive returns. Looking at data back to the 1870s, we find every decade delivered positive average annual returns or flat at worst (Chart 2).
However, looking at excess returns (the return of equities over cash), the picture changes dramatically. Almost half the decades delivered negative excess returns (Chart 3). The most recent was the 2000s, and before that was the 1970s. Worryingly, the late 1800s also saw negative excess returns despite the advent of the second industrial revolution, which saw the adoption of electricity, internal combustion engine and running water.
Aside from falling inflation and lower rates, the other factor that supported equities was declining corporate tax rates. Pretty much since the 1950s, there has been a steady and then rapid cut in Federal corporate tax rates (Chart 4). Of course, most corporates do not pay the sticker price and find all sorts of ways to reduce their tax burden. Indeed, the effective tax rate has been declining even more rapidly. But this trend is likely over. At best, tax rates may go sideways. At worst, they could increase as populism sees corporate power eroded.
The punchline is that stocks will struggle to perform in a world of higher rates and no longer declining tax rates. Our overall bias on equities is to stay neutral.