The Equity Duration Puzzle

Current Yield Environment:

• Global bond yields have fallen materially due to the COVID-19 shock and secular trends from previous years, resulting in a large proportion of global bonds currently trading at negative yields.
• This environment pushes investors up the risk curve toward equities, where yields remain relatively attractive.
• The yield gap between the S&P 500 and US 10-year yields is at one of the highest levels since the global financial crisis and the post-WWII period.
• Despite low bond yields limiting return potential, Goldman Sachs Research maintains that equities tend to outperform bonds over longer horizons.

The Equity Duration Puzzle:

• Historical Outperformance: Over the very long run, the average excess return of equities versus bonds is approximately 4% to 5%.
• Recent Divergence: Since the 1990s, the equity risk premium has largely disappeared in major markets, with equities struggling to outperform bonds during the 1990s and 2000s in Japan and post-financial crisis Europe.
• Secular Stagnation Drivers: Poor relative performance in recent decades was driven by falling bond yields signaling stagnation, forcing equities to de-rate long-term growth expectations.
• Current Outlook on Expectations: Long-term wealth expectations have significantly derated, resulting in conservative embedded expectations that are unlikely to drag performance going forward.

Risk Factors in the Current Market:

• Absolute Valuations: While relative valuations are attractive, US equities are expensive on an absolute basis, led by growth stocks that are trading at significant premiums.
• Duration Sensitivity: Growth stocks have become much longer-duration investments, meaning investors pay for cash flows further in the future rather than immediate dividends.
• Volatility Exposure: Increased duration makes equities more sensitive to disappointments, changes in the equity risk premium, and volatility in interest rates.
• Rate Sensitivity: The US market is particularly vulnerable to rate volatility due to the concentration of long-duration growth stocks; rising rates have already weighed on the market following vaccine developments.

Strategic Asset Allocation Recommendations:

• Overweight Stance: Goldman Sachs Research is leaning towards an overweight equities position for at least the next year, citing high equity risk premiums and limited bond return potential.
• Macro Backdrop: The outlook anticipates a continued global economic recovery from the COVID-19 shock with relatively limited inflationary pressures and rate volatility.
• Diversification Challenges: With bond yields near the zero lower bound, fixed income can no longer effectively buffer equity risk, necessitating alternative sources of diversification.
• Style and Geographic Shifts: Investors should consider reducing exposure to US growth stocks in favor of international equities, which offer lower duration.
• Sector Rotation: Recommendations include diversifying across cyclical and value sectors to mix with current growth leaders and mitigate specific regulatory or taxation risks associated with growth stocks.