Assessing how the debt ceiling will be resolved definitely leans to the art end of the spectrum. Evaluating the likelihood of a recession combines the science of analyzing economic data with the art of deciding how much weight to give to such models. Figuring out what scenarios are being priced into financial markets drifts closer to the science end, because we can quantify things like how many Fed rate hikes and cuts the market expects, or the risk skew in equity markets through option prices. All these considerations informed the latest House View update , in which we maintained our preference for high-quality bonds over equities.
For all that effort and analysis, sometimes simple math provides one of the most compelling arguments. Such is the case when we calculate potential total returns from now through year-end for US equities and US investment grade (IG) corporate bonds. These calculations don’t require a view on what will happen, only possible outcomes. The S&P 500 could end 2023 at any point in a wide range, but for simplicity we assume a low of 3300 (our bear case target), increasing by 100 point increments up to 4500 (our bull case is 4400). With the S&P currently at 4133, it’s straightforward to calculate the implied price return at each ending level, and then add 1% as an approximate dividend yield to produce the total return. The same logic applies to calculating potential IG bond total returns. The current index yield is 5.2%, and we assume it could end the year as low as 3.2% and as high as 6.4% (roughly our bear and bull targets), with the range divided by 20bps increments.
The result is see in Fig. 1 here, which shows clearly that IG bonds offer the better return in about 80% of outcomes. The columns are the ending level for the S&P 500 and the rows are the year-end IG index yield. Each cell is the difference between the implied total returns to IG and the S&P 500, for that given pair of year-end yield and index level. Assuming no change in the IG yield and S&P 500 between now and year-end, this should result in IG outperforming by between 0.9% and 3.3%. In our base case, the S&P falls to 3800, while lower Treasury yields reduces the IG index yield to about 4.7%. That implies IG outperforming by 13.5% to 15%.
These potential return calculations, which is pure science, give us comfort in our preference for IG bonds over US equities. There aren’t many scenarios where an investor loses by holding IG bonds versus the S&P 500. But even for those outcomes, the art of applying scenario probabilities reinforces the case for IG bonds. This is a subjective exercise, but the scenarios in which the S&P rises to 4400 or 4500 and IG yields increase more than 20bps are very unlikely. For equities to keep rising to year-end, much lower inflation and therefore
lower yields are almost a necessity. In the remaining scenarios where equities outperform, it’s by not much more than mid-single digits, versus double-digit return outperformance by IG in our base case.
This simple math argument for IG is based on an eight-month holding period, but other math helps to explain why equities have continued to grind higher the last month and why that could go on for at least a few more weeks. Two striking statistical developments over the past month are the steep declines in realized and implied volatility for the S&P 500, and the sharp drop in the correlation between S&P 500 and US government bond daily returns. Lower volatility and the negative correlation have induced rules-based systematic strategies such as risk parity, vol-targeting, and CTA momentum funds to increase risk, leverage, and equity exposure, and this technical tailwind may run a little longer.
The bottom line: The US macro outlook is highly uncertain, with risks skewed to the downside due to the potential aftershocks of the banking crisis. Yet equities are pricing in high probability of a perfect landing. That outcome is possible, but equities are unlikely to provide much return for the rest of the year even if it does materialize. In contrast, IG bonds should provide at least low-single-digit returns in all but extreme adverse outcomes. Thus, our preference for IG bonds over equities is premised as much on simple return calculations as it is on a cautious outlook. The math supporting high-quality bonds is also why we think investors should barbell their fixed income portfolio. With 3-month T-bills yielding nearly 5%, it’s tempting to take shelter in very short-duration securities. But if yields fall significantly because of a recession, those T-bills won’t provide the 10%+ returns that high quality bonds could. That’s just math.
Main contributors: Jason Draho, Leslie Falconio, Danny Kessler
Original blog: The math is the math , 24 April, 2023.
This content is a product of the UBS Chief Investment Office.
