Thoughtful investment decisions across asset classes may benefit from multiple approaches to analyzing and comparing them. For example, to compare the value of fixed income and equities, we typically use measures of yield: We calculate an equity risk premium and compare it to a fixed income yield. But suppose instead of looking at equities through the lens of yield, we look at fixed income through the lens of price-to-earnings (P/E) ratios?
The price of certainty: P/E ratios across asset classes
The chart below shows valuations measured in P/E ratios of 10-year U.S. Treasuries, U.S. investment grade (IG) credit and U.S. equities since 1990.
This chart is essentially a picture of how “certainty” and “uncertainty” are priced. Treasuries provide the most perceived certainty: a fixed income stream and, if held to maturity, no risk of capital loss (barring a default by the U.S. government). On the other end of the spectrum, equities represent uncertainty: no fixed cash flows and lack of clarity on future price levels. IG credit falls somewhere in the middle: a known income stream but with the risk of default.
What is clear is that the value placed on certainty has rocketed. U.S. Treasuries now trade at a P/E ratio of close to 70x, while uncertainty, in the form of equities, trades at a multiple of 20x. Credit, with its intermediate risk profile, comes in at 35x.
Relative valuation: Treasuries versus credit versus equities
In an uncertain world, it makes sense certainty should be richly priced. But there also seems to be an inexplicably large valuation gap between the mild uncertainty introduced by IG credit and the perceived certainty of U.S. Treasuries. Historical cumulative defaults in the U.S. IG universe have averaged a little over 1% annually over the past five years, according to S&P. By our estimate it would take default rates almost twice as large to justify the current discount to Treasuries. This is pretty hard to achieve barring a severe and protracted recession, which is not our outlook (though we see risks to the global economy rising over the longer-term horizon).
The discount for equities looks more justified. Earnings volatility on the S&P 500 Index is around 43%, compared to a price volatility of 15% (annualized five-year volatility averaged over a 30-year window). At these levels – and with the market giving low value to equities as an inflation hedge – it is easy to explain away the P/E discount. For equities to become appealing again, inflation expectations need to normalize and we need to see some recovery in earnings, which have been in recession since the second quarter of 2015. A cyclical outlook of relative calm could support that recovery.
For Treasuries, a PE of 70x may seem high, but extraordinary central bank policies such as asset purchases and fears of recession could conceivably push the Treasury P/E to infinity (if yields go to zero). Treasuries remain an important downside tail risk hedge and high-quality diversifier. But they come at an expensive price. It’s also important to maintain exposure to riskier assets that may benefit from any upside surprise. Credit is likely to remain attractive, while the jury is out on equities.