Bonds vs Equities: who’s right?

While bonds appear to be signalling an economic slowdown, equities are suggesting growth will continue. In this month’s video Investment Director, Ritu Vohora looks at the conundrum facing investors, with mixed messages emanating from bond and stock markets.

 

The first half of 2019 has ended with the strongest and broadest cross-asset rally in a decade. The last time gains were so broad was back in 2009 and 10.

Global equities have delivered their best June on record, as central banks around the world shifted towards an easing bias. The MSCI All Countries World index has now returned over 16%, in US dollar terms, year-to-date. May’s sell-off was largely reversed in June, with the US and Europe outperforming the global index, while Japan lagged the most.

Investors, however, remained closely tuned into political rhetoric, on the trade dispute between the US and China. Brent crude continued to rise on demand concerns, with attention also on tense geopolitics in the Middle East – which prompted a 10% spike in crude oil prices, since the middle of June. 

The 10-year Treasury yield plunged to below 2%, its lowest level since late 2016, as expectations grow of interest rate cuts to combat a sharp economic slowdown or recession. Gold surged on a dovish Fed, marking a six-year peak in June, and was the best performing asset class over the month.

All sectors finished June in positive territory, led by cyclicals including materials, tech and consumer discretionary. Longer-duration sectors lagged the most, including real estate, utilities and staples.

As we head into the second half of 2019, investors are facing a conundrum, with mixed messages emanating from bond and stock markets. Significant gains for both assets classes represents a rare combination. Bond markets appear to be signaling an economic slowdown and are more cautious, whilst equities are more buoyant, suggesting continued growth. Who’s right?

Arguably, the biggest development in financial markets in the second quarter has been the rally across global rates. 10-year US Treasuries have rallied in the past three months, and the front end of the US curve is now pricing in over 100 basis-points of easing by end-2020. Meanwhile, other parts of the world’s bond markets keep sliding into negative yield territory.

The global business cycle might be turning. Elevated trade tensions have put pressure on sentiment indicators in global trade and manufacturing and central bank rhetoric shows they stand ready to ease accordingly. Bond markets are pricing this in.

Yet, at the same time, risk assets are more upbeat. The US stock market is now back at all-time highs, with the S&P500 up over 18% on the year, while credit spreads in the US and Europe are well below the levels of December 2018.

The truth to what these signals may mean probably lies somewhere in between. Both markets are taking the same cues – a dovish turn from central banks. But why is the stimulus needed? If we assume the bond market is focused less on growth and more on the willingness of the Fed to act pre-emptively to forestall the risk of a recession, while equities are telling us that the Fed will, once again, be successful – perhaps both stories make sense. Additionally, investors have revised downward their assessment of “neutral” policy rates in the world’s major economies, most notably in the US. If this is correct and bonds are rallying because investors expect easing due to a recalibration of monetary policy, rather than purely for cyclical reasons, then the stock market move is more consistent with the bond rally. This argument is supported by the Fed recently marking down its long-term neutral rate significantly. The persistent weakness in inflation and market expectations in most major economies, also supports this theory.

Growth, is indeed slowing – particularly in the US as tailwinds of fiscal policy start to wane. Both soft and hard economic data are weakening, with Chinese industrial production growth slowing to its lowest rate since early 2002.

While there are real threats to growth conditions for a recession are not in place yet. US growth is slowing, but arguably it’s stabilising at a higher rate. China’s economy is also slowing to a more sustainable rate and should continue to be supported by policy stimulus. Monetary policy remains accommodative, the Fed has opened the door for rate cuts and the ECB has also adopted a more dovish stance. Furthermore, the US and China agreed to continue talks during a meeting of G20 leaders in Japan. While they failed to make significant progress towards a deal, President Trump said that additional tariffs would not be imposed “at least for the time being.”

The second half of the year promises to be an eventful one. The global economic expansion has matured and its health will be the key driver of relative equity market performance. But it is not over yet and central banks are actively trying to extend it. If US data does not change meaningfully, the Fed is likely to act pre-emptively and underline its commitment to avoiding recession. Nonetheless, the market may be exaggerating the size of the cuts. Ultimately, firmer earnings are required to push equities higher. Investors should expect slimmer returns and will need to be nimble to eke out returns over the coming months.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.