Keep it real...

The phrase “keep it real” typically refers getting back to basics, and this is what we are doing in the enclosed article. We take the unusual, and some would say, controversial step, of looking at “real” dividend yields. We also look at nominal bonds from a “real” point of view. Importantly, the low difference between the real yield on bonds and the real yield on equities, implies why investors accept low real yields; economic growth. Growth is essential to the equity investment rationale, and the prospects for strong economic growth in Australia are slim at this time; sub-par growth is with us for some time as China’s growth slows further. In this low growth context, a high real yield of around 4.5% real compares very well with real yields on corporate bonds over the recent past.

More specifically, we compare three main topics in the article:

1. Real yields on equities and corporate bonds over the recent past.
2. The differential between the real yield on corporate bonds and equities, as a way to imply expectations of economic growth.
3. Implied expectations to actual real GDP growth.

1. Real returns on bonds and equities

If equities are a great hedge against inflation, then one would expect that the equity yield, or the equity dividend divided by the equity price, might beat inflation in the short or medium term. However data presented in Figure 1 suggests that is not the case; equity yield less inflation is typically negative; around -0.41% on average. Now, the opposite is the case with nominal fixed income, which has an average real return of around 3.55%. These figures are derived from an estimate of the US 30 year corporate bond yield.

While this analysis uses US data, and takes no account of the franking treatment of Australian equities, the analysis tries to indicate the reasonable point that equity dividend yields are typically low.

Figure 1

Notice the real yield on the 30 year US corporate bond has trended lower for a very long time, and is currently around 3%, while the average real yield has been around 4.55%, which is roughly where the Sydney Airport inflation linked bond maturing in 2030 is at this point. In other words, if investors can buy Sydney Airport 2030s around the current yields, then that is like the average US investor going back in time, and purchasing bonds at a yield that is currently not available. While we do not think Australia is headed down the low growth track of the US, it will be impacted by the slowing of growth in China and the failure of the non-mining sector to take up the slack from the decline in the mining sector.

2. Real bond return less real equity return and implied economic growth

Many will say that the above analysis effectively “misses the point” as equity investment is “all about growth, or about the future, not the present”. In other words, the difference in real return between fixed income and equities should be attributable to the anticipated forward growth in the economy. Figure 2 shows the real return on bonds less the real return on equities. On average the premium, or real corporate bond return to real equity return, has been around 3.96% which implies roughly a 3-3.5% rate of GDP growth and resulting dividend expansion.

Figure 2 essentially reveals the implied forward estimate for US growth by the market, and we can note the following :

• estimates of US growth have been declining for many years
• estimates of US growth have now recovered, yet are still quite modest by historical standards,
• current compensation in bonds, compared to equities, is now higher than in the recent past

Figure 2

3. Implied growth and actual growth

So if we can create an implied GDP growth expectation, by taking real equity return from real bond returns, then it would be interesting to see how that implied growth matches actual growth. As Figure 3 shows, most of the time, one has received more than actual annual GDP growth by investing in US corporate bonds, as opposed to equities. In other words, you have been somewhat overcompensated by owning bonds for most of the past.

However, things started to change in 2008 and now the bond return is not as generous, relative to actual GDP, as it has been in the past. As we have argued elsewhere this is partly because of the Fed’s communication policy, or forward guidance; something the ECB has only just begun. [1] What the Fed is trying to do is to keep longer rates lower, as these lower rates will support economic growth, when short rates are now as low as they can go.

We imagine that the trend, evident since the late 1990s and recently intensified since 2008, of lower real corporate yields will not reverse in the short term. Rather, we expect that economic growth will be moderate by historical standards, meaning that growth in equities will remain volatile as weaker than typical growth and inflation continues to support lower than typical rates.

Figure 3

Conclusion

While the Bernanke speech was not going to be a positive for equities, it has created opportunities in bonds that pay a real return. Looking back over time, one can see that equities are a poor hedge to inflation, based on a real dividend yield. Rather than providing real yield, equities provide exposure to economic growth. To be overweight equities, therefore, one has to be very confident of strong growth, and while we are confident of growth, we are not confident of strong growth. That is the problem with equities right now, especially with the chill wind of a Chinese slowdown blowing at this time. By comparing the real yield on bonds to the real yield on equities we revealed the expectations of growth that have been implied by US equity and bond yields.

Bond real yields have contracted to low levels by historical standards, which make the current real yield on the Sydney Airport 2030 inflation linked bond all the more attractive. Moreover, at roughly 4.50% real, the Sydney Air return of 7%, namely 4.50% real plus 2.50% inflation is a very attractive proposition in a market with cash rates headed to 2.50% for the foreseeable future.