19 Feb 2018
It was a near-perfect year for risk assets in 2017, but the road ahead looks more challenging. Why? Asset valuations have risen across the board, market volatility has stayed very low and many perceived risks have not materialised. This makes markets more vulnerable to temporary sell-offs if any risks, such as those discussed on page 10 of our Global Investment Outlook, bubble over.
US equity risk premium and investment grade (IG) credit spread, 1995-2017
The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Bloomberg Barclays and Thomson Reuters, November 2017. Notes: The IG credit spread is represented by Bloomberg Barclays US Investment Grade Credit Index. The US equity risk premium is calculated as MSCI USA Index’s dividend yield plus expected dividend growth minus the expected real rate. The real rate is the 10-year US Treasury yield minus expected inflation and a BlackRock estimated term premium.
The risk premia on all financial assets has declined. Our measure of the US equity risk premium – one gauge of equities’ expected return over government debt – has fallen since the global financial crisis. See the Shrinking rewards chart (above). We believe overall market returns will be more muted as a result, making selectivity key. We prefer to take risk in equities, particularly non-US stocks. See page 12 of our Global Investment Outlook for more. We believe structurally low interest rates mean equity multiples can stay higher than in the past.
US high yield bond and equity prices, 2015-2017
The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Bloomberg, November 2017. Notes: The dots show monthly observations for the par-weighted price for the Merrill Lynch US High Yield Index (y-axis) and the Russell 2000 Index (x-axis) from January 2015 to November 2017.
Economic expansion supports both equities and credit, but we prefer to take risk in the former. US credit spreads against Treasuries are near their mid- 2000s lows. Such tight spreads mean that even a small sell-off can wipe out credit’s extra income over government bonds. And investors’ thirst for yield has tipped the balance of power in favour of issuers: loans carry fewer protections and corporate leverage is on the rise.
We see credit offering coupon-like returns, making it a useful source of income. But when bonds trade near or over par, as they do today, there is little potential price upside. The Where’s the upside? chart (above) illustrates this dynamic for US high yield. By contrast, credit prices tend to fall hard in any equity sell-off as default worries come to the fore, albeit by less than equities. Bottom line: equities offer far greater upside than credit as the cycle matures, we believe.
Important information: Risks
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