Gulf in S&P 500 and Treasury returns likely to shrink - Capital Economics
Asset Allocation

Gulf in S&P 500 and Treasury returns likely to shrink

Asset Allocation Update
Written by John Higgins

We expect the S&P 500 to outperform Treasuries by much less in 2020 than in 2019, as government bond yields edge up, the equity risk premium stops tumbling, and corporate earnings continue to disappoint.

  • We expect the S&P 500 to outperform Treasuries by much less in 2020 than in 2019, as government bond yields edge up, the equity risk premium stops tumbling, and corporate earnings continue to disappoint.
  • While US large-cap equities and government bonds both had a good run last year, there was a gulf in their performance – the returns from the S&P 500 and ICE BoAML’s US Treasury Index were 31% versus 7%.
  • This partly reflected the rally in government bonds itself. Admittedly, the 80bp-odd fall in the nominal yield of the Treasury Index, which includes bonds with an average life of about eight years, is likely to have exceeded the drop in the risk-free component of the average real yield used to discount the future earnings of S&P 500 firms. But, all else equal, the prices of equities are more sensitive than those of conventional bonds to changes in risk-free yields because their average cash flow occurs further in the future.
  • Accordingly, the drop in the Treasury index yield only translated into a capital gain of 4-5%, whereas an estimated drop of only 50bp or so in the risk-free component of the equity discount rate (equal to the drop in the ten-year TIPS yield implied in ten years’ time – see Chart 1) probably boosted the S&P 500 by more.
  • Meanwhile, the equity risk premium (ERP), which is the other component of the equity discount rate, is likely to have fallen sharply too. Admittedly, the ERP cannot be observed directly. But the option-adjusted spread (OAS) over Treasuries of the S&P 500 Bond Index – which is designed to be a corporate-bond counterpart to the S&P 500 – fell by nearly 60bp, to just under 1.0%. (See Chart 1 again.)
  • Pulling in the opposite direction was a small reduction in the average real expected growth rate of earnings. We infer this by plugging our estimates of changes in the two components of the equity discount rate (the risk-free component and the ERP) into an earnings discount model.
  • We project that the gap between the returns from the S&P 500 and the Treasury Index will be much smaller this year. (See Chart 2.) One reason is that we don’t foresee another drop in government bond yields, given our non-consensus view that the Fed has finished cutting rates. On the contrary, we forecast that the 10-year yield will end 2020 at 2.0%, which compares to a level now of around 1.85%.
  • Meanwhile, we doubt that the ERP will fall further either, as appetite for risk is dampened by irreconcilable differences between the US and China and uncertainty about the US elections. What’s more, while the risk premiums of equities and bonds differ, the credit spreads of corporate bonds are generally very low by past standards in many cases. Indeed, the OAS of the S&P 500 Bond Index is now close to its early-2018 trough.
  • Finally, analysts didn’t scale their lofty forecasts for corporate earnings in 2020 and 2021 back much when profits faltered last year. Their forecasts, which presumably reflect optimism that the global economy will enjoy a broad-based recovery rather than the uneven upturn that we envisage, remain too rosy in our view.

Chart 1: Proxies* For Components Of S&P 500 Discount Rate vs. S&P 500 In 2019 (%)

Chart 2: Total Returns From S&P 500 & US Treasuries, Actual & Projected (%)

Sources: GSW, S&P, Bloomberg, CE

Sources: Bloomberg, Refinitiv, CE


John Higgins, Chief Markets Economist, +44 20 7811 3912, john.higgins@capitaleconomics.com

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