The asset class offering the best value now

I give an update about every six months of the yields offered on key asset classes and how they compare. Here’s the latest chart for the four major asset classes: cash, bonds, property, and stocks. And I’ve included the inflation rate as a point of comparison.

You’ll quickly notice that the yields on cash, bonds and property are closely aligned, though they remain well below the inflation rate. In other words, these three asset classes are currently offering negative real yields (inflation rate minus asset class yield).

On the face of it, this doesn’t make sense. You’d normally like to invest in an asset class that has positive real yields so you can keep pace with, or exceed, inflation. Yet Australian 10-year bonds for instance, offer a yield of 4.01%, well below the inflation rate of 5.60%. If you buy a 10-year bond at par at that yield and hold onto it for the next decade, and the inflation rate remains at current levels, you’ll lose money in real terms. That is, your money will have less purchasing power at the end of that period.

The question is: why are assets such as bonds priced at these levels given where inflation is? Much of the answer lies with expectations that inflation will fall. These expectations were buoyed from recent figures showing the consumer price index (CPI) rose 5.6% year-on-year in May, compared to economist forecasts of 6.1%.

After the CPI rose from close to 0% at the start of 2021 to almost 8.4% in December 2022, it’s fallen sharply over the past six months.    

CPI

Inflation bulls will tell the bears: hang on a moment. While the latest CPI report is welcome, the seasonally adjusted CPI was higher at 5.8% and the trimmed mean CPI was at 6.1%. On the supply side, the fraying of globalization could mean supply chains may not return to what they were pre-COVID. And pricing pressure will remain given significant wage increases being pushed through at the start of July, rental increases, while easing, remaining high, house prices rising off their lows, food inflation increasing at the major supermarkets and energy prices showing no sign of abating as the transition to green energy proves difficult and costly.

The inflation bulls will also point to research from Research Affiliates’ Rob Arnott that suggests once US inflation reaches above 8%, as it did last year, history shows that reverting to 3% usually takes 6 to 20 years, with a median of over 10 years. Where the US goes, Australia normally follows.

Most asset classes need inflation to fall towards the RBA’s target, otherwise current pricing doesn’t make a lot of sense.

Cash is sexy again

Just 18 months ago, cash was trash. Now, it’s back in a big way. That’s thanks to the RBA lifting interest rates from a low of 0.1% in April last year to 4.1% today. It’s been a wild ride over the past 14 months!

RBA cash rate

You can now get a Commonwealth Bank 12-month term deposit rate of 4.25%. Other banks pushing hard into the deposit space offer better. Macquarie Bank has 12 term deposit rates of up to 5% while Judo Bank has term rates of up to 5.3%. These can come with terms and conditions, so make sure you do your homework.

Are bonds back, or is it just a furphy?

Bonds had a disastrous 2022 and investors ran for the exits. Bonds have steadied so far this year, and many fund managers are proclaiming that bonds offer good value.

I’m not so sure. After all, you can get more yield in cash than in 2 or 10-year government bonds. There’s also the problem of high inflation. Sticky inflation is bad for bonds as it erodes the purchasing power of a bond’s future cash flows.

Switched-on readers may have noticed earlier that 2-year bonds yield more than 10-year bonds. In economic terms, that’s an inverted yield curve as short-term yields are higher than long-term yields, so the yield curve slopes downwards. An inverted yield curve can mean investors believe interest rates in future will be lower than the current rates.

In the US, an inverted yield curve has been a prescient harbinger of a coming economic recession because central banks reduce policy rates in response to lower economic growth and inflation, which investors may correctly forecast will happen.

In Australia, an inverted yield curve has been less reliable as an indicator of a future recession.

Is residential property set for a double dip?

The size of the residential real estate market in Australia boggles the mind. At $9.6 trillion, it dwarfs the likes of superannuation and listed stocks.  

The latest figures show that residential property continues to bounce off lows. Nationally, home values increased 1.1% in June, and are up 3.4% from their bottom in February. Sydney has led the way, with property prices 6.7% higher from the trough. The ACT, Tasmania, and the Northern Territory, have lagged, barely rising from their lows.

Source: Corelogic

Where do prices go from here? On the one hand, the extraordinary migrant intake is likely to prop up demand for both home purchases and rentals. Record low unemployment will also help. On the other hand, the bulk of fixed income mortgages are expiring this year, and that will provide a large hit to people’s disposable income and ability to buy a home.

What is unarguable is that rental yields on residential property remain terrible. At gross yields of 3.88% nationally, homes are effectively priced at 26x earnings. And that’s before costs which can bring those gross yields down 1% or more.

Source: Corelogic

It’s not a great deal from an investment viewpoint. For it to work as an investor (as distinct to buying a home to live in), you’re banking on strong rent rises continuing well into the future, which could well happen.

What a comeback for US stocks

At the start of this year, many pundits were predicting more doom and gloom for US stocks and, not for the first time, were wrong. Very wrong. After diving 18% and 33%, the S&P 500 and Nasdaq have roared back in the first half of 2023, returning 17% and 39% respectively.

What’s driven the turnaround? Declining inflation rates and a potential pause in interest rate increases have certainly played a part. So has the rise of Artificial Intelligence and investor enthusiasm for anything related to this technology.

Eight stocks have driven much of the S&P 500’s rise to June 30:

1. Nvidia +190%
2. META + 138%
3. Tesla +113%
4. Amazon +55%
5. Apple 50%
6. Netflix +49%
7. Microsoft +43%
8. Alphabet +36%

This compares to the S&P 500 equal weight ETF (RSP) rising 7% in the first half of the year.

The rally has made US stocks look very expensive, once again. The S&P 500 trades at an earnings yield of 3.88% or a price to earnings ratio (PER) of almost 26x. 

S&P 500 earnings yield based on trailing 12 months earnings

Source: Robert Shiller

And on a cyclically adjusted PER, using average inflation-adjusted earnings from the previous 10 years, things look worse. At 31x, it’s 80% above its long-term average of 17x, and is at levels only seen in 2000 and 1929.

Cyclically adjusted PER or CAPE ratio

Source: Robert Shiller

And with the US 10-year bond yielding 3.85%, US stocks offer no premium to the risk-free rate. Note that investors normally demand a premium to the risk-free rate, sometimes a substantial premium, for them taking on the risk of buying stocks. That’s not the case now, and it doesn’t bode well for future returns for US stocks.

ASX stocks: the value play?

The Australian stock market has had a dull time of it compared to other markets. It’s had a small gain this year, trailing most developed markets.

Country ETF returns in 1H23

Source: Charlie Bilello

The ASX been held back by the performance of the heavyweight sectors in banks, energy, and materials. Banks have underperformed as profit margins are getting crunched from increasing the interest rates paid on deposits due to political pressure and competition for deposits.

Meanwhile, energy and mining stocks have struggled as the prices of oil, iron ore, gold, copper, and lithium have all retreated from their peaks of last year.

Source: Viridian Financial

Yet, the ASX stocks are one of the few assets that look reasonably priced. At an earnings yield of 6.76%, the All Ordinaries is priced close to its long-term average. And it offers a nice premium to risk-free bonds.

Of the four major asset classes in Australia, stocks seem to offer the best value at this point.

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au