There’s a puzzle at the heart of this month’s Strategy Review on US equities. All four interviewees run defensive portfolios – one is so bearish, he expects a re-rating to 10 times earnings – but have struggled to keep pace with a rally led by quality defensives.

Their problem is lack of exposure to banks, which, seven months ago, decisively broke their correlation with other cyclicals and began trading in line with quality defensives.
No-one thinks banks are set to lend and grow again – this is all about the Fed setting up a nice roll-down-the-curve trade. That’s also why quality defensives and their free cash flow remain attractive: they don’t need loans and they might even hike your dividends.

In other words, this is a liquidity-trap trade. Not only is it not a ‘great rotation’ out of bonds, it’s not even a rotation into equity, really. Investors see negative real short rates paired with a steep curve as far as the horizon, and are responding with attempts to engineer equity-like real returns in fixed-income form.

High-yield bonds are part of the story. But consider Warren Buffett’s 9% preference shares in Heinz, too: isn’t that protection against the risk of low earnings growth? And what about Apple’s cash? At least one of our Strategy Review interviewees thinks that it will eventually pay for another blockbuster gadget, but David Einhorn and most of the rest of the market just see 2% real-terms losses leaking out the door and no growth prospects. They’re begging for a Buffett-like ‘iPref’ – the closest we’ll ever get to an Apple bond.

Negative real rates are meant to scare you into realising that everything investment grade will destroy your capital in real terms, and to take equity risk to compensate. But the key word is ‘compensate’. As GaveKal’s Louis Gave estimates, if we repeat the long-term real return on the world’s equity for the next five years, it will only match the real capital destruction in the world’s sovereign and corporate investment grade bonds. So even if regulators didn’t forbid it, it would be a courageous European pension fund that took such risk, just to get a flat real return, after years of re-investing into bonds paying negative real rates. Better to take income and a hit on the bonds, and pray that quality defensives hike your dividends. This is the story of ‘investment’ in Japan over the past 20 years.

Investors taking the long view prefer not to risk investment in long-term growth. This is not sustainable: even Apple’s cash will run out some day, and on that day its shareholders might find themselves no better off in real terms. That may be a structural, demographic problem. But even if it isn’t, investors probably won’t take genuine long-term equity risk until rates go up – and valuations come down.