In today’s market conditions, we think it makes sense to slightly overweight equities and modestly underweight high-quality bonds, and diversify more broadly than usual.
In our view, the stock market currently appears relatively attractive for several reasons: Moderation in volatility due in part to stabilization of oil prices, data confirming low economic growth will continue (despite issues such as recent US employment data and worries over a potential Brexit), and valuations that may not be cheap but are offset by high-quality company balance sheets.
And, we believe, this small increase in equity risk is partially offset by the fact that the diversification benefit of owning high-quality bonds is slightly higher than normal.
Taken together, these factors make us favor stocks—but our near-term return expectations for stocks are also modest, and we are wary of a potential reversal if sentiment shifts suddenly, as it has several times in recent months.
One way to favor stocks while reducing downside risk is to establish a modest position in equity index call options. These options offer equity market upside with limited downside risk, and today’s low volatility makes them unusually inexpensive.
But that’s not the only way to seek near-term return potential, while reducing downside risk. High-yield bonds and real estate securities both tend to rise and fall with stocks, but their strong income component gives them a distinct risk profile that is particularly useful in today’s market environment.
When expected returns from equities are low, as they are now in our analysis, the income from high-yield bonds and real estate securities is particularly valuable. You can see this in the Display, which illustrates our view of the relationship between the expected returns of equities and high-yield bonds today. The pattern for real estate securities relative to stocks is similar.
If equity markets trend downward, the income from high-yield bonds is likely to soften the blow, in our view. Even if equity-market returns are flat or very low, high-yield is likely to lead. Stocks would only outperform high-yield, however, if very strong stock-market gains outweigh the income benefit from high-yield.
If high-yield offered a lower income advantage, even very low stock-market returns would beat high-yield returns. If expected returns for stocks were higher, on the other hand, high-yield wouldn’t look nearly as attractive as it does today.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.