Stocks to outperform bonds


  • Bonds continue to materially underestimate the long-term prospects for growth and inflation
  • Relative valuations suggest a sizeable cushion for stocks to outperform bonds
  • The multi-year nature of this theme allows us to de-emphasise timing the cycle

Long-term growth prospects

Our ability to guess where long-term interest rates should eventually settle is clouded by all sorts of unknowables. However, the idea that the prevailing interest rate in an economy, plus a compensation for taking risk, should broadly equal the rate of return on productive capital (roughly speaking nominal GDP growth) is intuitively sensible.

Intense competition for the use of capital in an economy by governments, corporations and households should, in theory, mean that the margin between the cost of capital and the return on capital is minimal.

Figure 1 tells us that there is more than just intuitive sense to this idea. It also highlights that the gap between nominal US GDP growth and bond yields is wide and so far unresponsive by historic standards. The world economy is simply not broken in the way that the dismal scientists and bond markets require it to be. This suggests tougher times ahead for bond markets as that truth becomes more evident.

Relative valuations

Relative valuations still suggest significant scope for stocks to continue to outperform bonds. Prospective annual returns from stocks can be estimated by adding together the dividend yield with a sensible estimation of prospective GDP growth.

To make this a relative return, we simply subtract the bond yield. Over the last 20 years, developed world dividend growth has roughly tracked global nominal GDP growth. With global government bond yields lurking around 1% and the developed world corporate dividend yield sitting just above 2% (not accounting for US net buybacks) we would have to make some fairly apocalyptic nominal global output growth assumptions to see stocks failing to outperform bonds on a strategic timeframe

Don't worry about the cycle

As it goes, the world economy seems to be exhibiting as many mid- as late-cycle symptoms at the time of writing. However, this call is independent of the cycle, looking to a timeframe where valuations actually do start to matter.

An aging population is no doubt a factor to consider with regards to long-term interest rates, but humility remains appropriate when predicting the activities of the future pensioner – improving health and longevity may mean we work for longer, save for less. Meanwhile, the fact that mankind is advancing into uncharted territory in robotics, artificial intelligence and genetic engineering among other disciplines suggests default pessimism on mankind’s productivity potential may well be misplaced.

Following this theme is essentially a bet on mankind’s restlessness and seemingly inexhaustible capacity for innovation – something the bond market seems to be materially underestimating as that multi-decade bull run in fixed income draws to an end.

The stock market, on the other hand, should continue to benefit from such continued economic progress. Bonds will continue to play an important diversification role in portfolios. However, with starting yields so low, the contribution of the high quality corners of the fixed income complex to portfolio returns over the next few years can only be small to negative.

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