Both bond and equity markets “now factor in sharply different views of the world”, according to Bank of America Merrill Lynch investment strategist James Barty.
Differences in outlook have surprised some as both equities and bonds have moved in step with each other over recent time frames.
Barty said: “At the end of last year, it seemed all markets were joined at the hip. Equities, and in particular cyclical equities, were rallying hard, bond markets were selling off and the US dollar was surging to new highs.
“2017 has seen that synchronisation unravel.”
Indeed, the divergence has emerged this year as bond investors have focused on hard data. Bond yields have pulled back – although some more cyclical parts of the equity market have also struggled.
Barty said the bank’s fixed income strategists believe the bond market is pricing a policy error by the Federal Reserve.
He added: “Given some of the implied rise in rates is simply risk premium, we think the US bond market is implying a sharp slowdown in US growth to trend or even below.
“The reason equities have been able to rally this year, despite falling bond yields, has been because earnings have been so strong.
“MSCI ACWI earnings are now expected to be 14 per cent for this year, 11 per cent for 2018 and 10 per cent for 2019.”
Performance of MSCI ACWI over 1yr
Source: FE Analytics
He said: “If equity markets are right then bond yields need to rise sharply. If bond markets are right, then equity markets could have circa 13 per cent downside wiping out the vast majority of the post-US election rally.
“The US would be the seem to be where this discrepancy is highest with the most expensive equity market but the bond market refusing to believe the Fed can tighten much at all.”
If equities markets are correct, said Barty, then US rates will have to move 50 basis points higher.
“Bond markets imply a sharp slowdown in growth, equities assume upswing continues. Something has to give,” he said. “We think it's rates.”
A rise in rates could hurt bond prices in the low-yield environment in the longer term and the Bank of America Merrill Lynch analysts believes the Federal Reserve is more in tune with equities markets than it is with bonds.
The investment strategist added: “As a house, we are in the camp of equity markets moving higher and think growth will remain solid and synchronised.
“We look for the rally in equities to continue and for yields, particularly in the US, to adjust upwards.”
Greater liquidity in the market has helped push growth stocks higher, with the firm’s chief investment strategist labelling $1.1trn in asset purchases by central banks as a ‘liquidity supernova’, noting: “The renewed combo of low growth, inflation & yields have propelled US growth stocks above their 2000 ‘tech bubble’ highs versus global value stocks.”
However, Barty said greater levels of liquidity in the economy had only been one part of the story and highlighted improved earnings.
“Growth stocks are not simply being pushed up on liquidity they are also seeing very strong earnings revisions,” he said.
“The US earnings season was the best in 13 years and the European one the best in at least 15 years. That we attribute to the synchronised upswing in global growth.”
Performance of earnings revision indices since 1988
Source: Bank of America Merrill Lynch
While the firm has hedged positions, it continues to back core long equity positions. Barty said Asia ex Japan had been the best performing region after returning more 20 per cent since the start of the year.
Strong performance from Asia was boosted by the strength of Asian currencies against the US dollar, although it has been more tactically cautious towards China over the prospect of increased tightening.
The strategist said it has taken more cautious stances despite its constructive view of market conditions.
“While some argue that valuations are stretched we that any premium to history is modest and needs to be put into the context of the valuation of other asset classes,” he noted. “While the US equity market trades on 18.5 times forward earnings, the 10-year Treasury yields less than 2.2 per cent.
“One is a real yield of a little over 5 per cent, the other is offering a real yield that is barely positive if we assume the Fed meeting its inflation target over the medium term.
“Even if we assume that it doesn’t and that it, for example, only averages 1.5 per cent over the medium term you are still looking at an excess return from holding equities in excess of 4 per cent.”
The firm maintains its long positions in MSCI Asia ex Japan and in Europe via its yield basket, he said, although it moved into more defensive positions as the cyclical rotation gathered pace last year.
Bigger positions in utilities, telecoms and pharmaceuticals have protected it from the more recent shift in markets towards more defensive stocks.
He added: “Yield is still one of the key attractive characteristics of the European market and we think flows may well continue to move in to equities given the lower level of yield on offer n higher yield now.”