Are risk premia high enough?

In the AFR I write this weekend (brief excerpt only):

One especially interesting canary in the coal mine that implies monetary policy is not nearly as restrictive as central banks believe is the global house price action. While Aussies like to think that our housing market is different, there has been a striking and globally coordinated bounce in house prices in Australia, the UK, US, Canada and New Zealand since the end of 2022.

Although this rebound has been modest and has yet to claw back the historically large losses endured since global housing markets rolled over in unison in early-to-mid 2022, it has interestingly coincided (albeit with a lag) with the recovery in other risky asset classes, such as equities and utility-free crypto.
Coolabah’s chief macro strategist, Kieran Davies, comments that “it seems likely that house prices will resume falling when unemployment rates rise, although the signal for many central banks is that the recent resilience in prices casts doubt on how tight policy actually is for households”.

I further ponder what precipitated the recent risk rally:

One explanation is the false dawn in global headline inflation rates declining in late 2022, which has unfortunately not translated into sufficiently strong mean-reversion in the underlying inflation pulse.
This in turn prompted the widespread belief in late 2022 and early 2023 that we were close to the completion of the central banks’ hiking cycles. At one stage, there was, in fact, bizarrely as much as 100 basis points of rate cuts priced for the US Federal Reserve by the end of this year, the prospect of which the Fed has subsequently quashed.
So hopes for rate cuts in 2023 have been dashed and terminal cash rates keep getting repeatedly revised upwards, which equities have until very recently ignored. Given the unprecedented nature of the fiscal and monetary policy stimulus unleashed during the pandemic, the truth is that nobody really knows where the final cash rates will land – they will be determined by the data on jobs, wages, and inflation...

I also argue that equity and property risk premia look very poor at present:

What we do know with certainty is that the risk premium offered by equities, commercial real estate and residential property, to name a few, beyond the risk-free interest rates available on cash, government bonds and very low-risk assets such as high-grade bank bonds are pitiful right now.

The dividend yield on Aussie equities, grossed up for franking credits, is 6 per cent. In the much lower-yielding US equities market, dividend yields are only 1.6 per cent. This makes for an awkward juxtaposition against Aussie and US cash deposit rates and 10-year government bond yields paying 4-5 per cent. CBA’s AA- rated senior-ranking bonds offer interest rates of 5.3 per cent while its BBB+ rated Tier 2 bonds pay 6.5 per cent. CBA’s hybrids, which carry franked distributions rather than cash interest rates like senior and Tier 2 bonds, are yielding 7.2 per cent.

This is why the likes of Australian Super, which manages over $275 billion, and many other large institutional investors are shifting their asset allocation back into fixed income having been underweight bonds for decades.
Over the 12 months to June 30, dwelling values across the capital cities fell by about 5 per cent, clawing back from what was a peak-to-trough slump of 10 per cent using CoreLogic’s daily data. Faster-moving listed Aussie equities recovered from their 7.4 per cent loss in the 2022 financial year to post a 14.75 per cent gain in the 2023 financial year.
In Coolabah’s actively traded institutional bond portfolios, we generated north of 11 per cent over the same period, while our similar retail products returned 8.4 per cent net of fees. Over the same period, the AusBond Floating-Rate Note Index delivered 4.03 per cent. In contrast, the fixed-rate AusBond Composite Bond Index furnished only 1.24 per cent due to the impact of rising government bond yields.
Whereas floating-rate notes profit from higher interest rates as the interest they pay gets ratcheted up every quarter in line with moves in the RBA cash rate, a fixed-rate bond – which has its interest rate fixed for the life of the bond – suffers a price decline (increase) as yields increase (decrease).
As interest rates do approach their terminal points, savvy investors will doubtless start fixing their yields, and locking-in “interest rate duration” exposures, which could provide attractive returns – and a powerful hedge against drawdowns in equities etc – if and when central banks do indeed get around to cutting rates as the global recession grips.

The full AFR column can be read here. Also have a look at Coolabah's new Floating-Rate High Yield Fund here.