Bond bulls give holiday thanks: at least we're not stock bulls

(Bloomberg) --Wounds are running deep in fixed income after the worst year for bond bulls in a generation. Deep enough to spring a recovery? Beset with bleak alternatives, some investors are finding the courage to say yes.

Particularly when the main alternative is stocks, whose fortunes have lately begun to veer noticeably from their stodgier brethren — equities' performance versus Treasuries in December is the worst for any month in two years. As recession clouds gather amid signs inflation may have peaked, safe yields approaching 4% on a swathe of government securities and 5% for blue-chip corporate debt strike many managers as decent value in a world bathed in uncertainty.

Rather than just seeking haven plays, money managers are looking to go on the offense in the bond market heading into the new year. Soaring yields across the fixed-income landscape have whittled the valuation premium stocks have long been able to claim, muzzling the "there is no alternative" mantra that's defined investing for much of the last decade.

Further fueling the change is a darkening outlook on corporate earnings, with many on Wall Street still doubtful that 2023 estimates have any basis in reality. Not to mention, the average forecast among strategists tracked by Bloomberg calls for the S&P 500 to decline next year — the first time that the aggregate prediction has been negative since at least 1999. That threatens a wakeup call for stocks in 2023, with the likes of Morgan Stanley and Citigroup warning more volatility awaits equities. 

It's a backdrop that benefits bonds of all stripes, in the eyes of Nuveen's Brian Nick. 

"If you don't think you're headed for that worst-case economic scenario, you don't want to be in equities just because we think the earnings numbers will be disappointing," Nuveen's chief investment strategist said in a Bloomberg Television interview. "But being in credit, if you think default risk is pretty low and you're getting — depending on the credit rating — 5% to 9% if you're looking at high-yield, those are places where we think investors are going to be able to make money."

The bond bullishness follows a brutal year for the asset class amid the worst inflation in 40 years, pushing the Federal Reserve to unleash 425 basis points of rate hikes since March, with the promise of more to come. Policy makers' median projection for the central bank's so-called terminal rate currently stands at 5.1% at the end of next year, with Fed Chief Jerome Powell warning last Wednesday he couldn't confidently say the peak won't move higher.

After entering the year near 1.5%, benchmark 10-year Treasury yields are currently trading around 3.5% after surging above 4.3% in October, delivering the worst losses in decades. Meanwhile, returns on investment-grade corporate bonds have plunged more than 13% this year, Bloomberg data show.

Equities haven't fared better. Higher interest rates have scorched growth-oriented technology shares, which command the most heft in the S&P 500. That's dragged the benchmark more than 19% lower in 2022, breaking three straight years of double-digit gains and poised for the worst performance in more than a decade.

However, fortunes are expected to diverge next year. The selloff in bonds has dramatically cut duration risk — a measure of sensitivity to interest-rate changes — while elevated yields mean clipping coupons is an attractive proposition. Corporate defaults have been historically low, with Goldman Sachs estimating that the current 12-month trailing default rate for high-yield debt currently stands at 1.2%, versus a long-run average of 4.5%.

But for equities, more pain is seen in the offing as earnings reports roll in. 

"We haven't seen the rate of revisions that you would expect to see in corporate profits feed through. So we expect that to happen, so we're cautious on equities right now," abrdn Plc Chief Executive Officer Stephen Bird said in a Bloomberg Television interview. "Bonds, having had a horrible year in 2022, particularly in duration, are a good place to be invested in 2023."

Bloomberg Intelligence anticipates earnings per share for companies in the S&P 500 to climb just 2.7% next year, to $229.7 from $223.6 in 2022. Even after multiple downgrades, those expectations are still out of step with the economic reality, Morgan Stanley Wealth Management's Lisa Shalett said this month, setting up markets for a "rude awakening."

In addition to a darkening profit forecast, higher yields mean equities have been steadily losing their edge to bonds all year. The so-called Fed model — which plots the S&P 500's earnings yield against that of 10-year Treasuries — shows that the benchmark's advantage over bonds is around the slimmest levels in a decade.

The same exercise applied to blue-chip corporate bonds produces largely the same result. Relative to its price, the S&P 500 "pays out" roughly 5.4% in earnings, versus the 5.1% average yield on US investment-grade debt. That 0.3 percentage-point gap is among the narrowest since late 2009, Bloomberg data show. 

"We don't believe we're getting paid for being in the stock market going into the next quarter," Amy Kong, chief investment officer at Barret Asset Management, said in a Bloomberg Television interview. "Any excess cash, we have been focusing more and more in the bond markets, where yields are starting to look more attractive."