Bonds have become more attractive as an investment opportunity due to weaker inflation readings and expectations for Fed rate cuts in 2024. The “higher for longer” mantra has been replaced by the optimism of potential rate cuts in 2024. We should also note the risks. I have been adding selectively in recent months.
In their 2024 outlook, PIMCO’s asset allocation team states they strongly favor fixed-income in multi-asset portfolios. In the report, they highlight bonds resilience, diversification, and attractive valuations compared with equities. They also state they are neutral stance on equities and are focusing on quality and long-term resilience.
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Growth has likely peaked, but so has inflation, in our view. As price levels get closer to central bank targets in 2024, bonds and equities should resume their more typical inverse relationship (i.e., negative correlation) – meaning bonds tend to do well when equities struggle, and vice versa. The macro forecast favors bonds in this trade-off: US Treasuries historically have tended to provide attractive risk-adjusted returns in such a “post-peak” environment, while equities have been more challenged.
Delving deeper into historical data, we find that in the past century there have been only a handful of instances when US equities have been more expensive relative to bonds such as during the Great Depression and the dot-com crash. One common way to measure relative valuation for bonds versus equities is the equity risk premium or “ERP” (there are several ways to calculate an ERP, but here we use the inverse of the price/earnings ratio of the S&P 500 minus the 10-year U.S. Treasury yield).
The ERP is currently at just over 1%, a low not seen since 2007. History suggests equities likely won’t stay this expensive relative to bonds; we believe now may be an optimal time to consider overweighting fixed income in asset allocation portfolios.
Price/earnings (P/E) ratios, are another way that equities, especially in the US, are screening rich, in our view – not only relative to bonds, but also in absolute. Over the past 20 years, S&P 500 valuations have averaged 15.4x NTM (next-twelve-month) P/E. Today, that valuation multiple is significantly higher, at 18.1x NTM P/E. This valuation takes into account an estimated increase of 12% in earnings per share (EPS) over the coming year, an estimate we find unusually high in an economy facing a potential slowdown.