As a result of ultra-low interest rates and huge levels of intervention from central banks like the US Federal Reserve, both fixed income markets and equities have performed well since the period after the financial crisis as quantitative easing has pushed bond yields lower, forcing investors into higher risk assets.
More recently, the correlations have become even greater as, according to FE Analytics, the S&P 500 has returned 21.6 per cent over the last year and, while not as high, the Barclays Global Treasury index is up a hefty 7.78 per cent.
Performance of indices over 1yr
Source: FE Analytics
However, as both asset classes are being driven by different sides of the same macroeconomic coin – with the equity rally suggesting everything is rosy in the US economy while current bond yields reflect the complete opposite – Guy Stephens, director at the Rowan Dartington Signature, warns that something has got to give.
“The equity markets and bond markets feel very polarised in our view – both remain confident but both can’t be correct,”
Stephens (pictured) said.
He adds there are a number of factors why the two asset classes are so polarised. He points to the fact that recent data shows the US economy is performing well as monthly unemployment payrolls beat forecasts and the previously strong figures from the prior two months were also upgraded.
He says if you combine those positive figures with recent quarterly GDP data, which suggests growth will be 5 per cent per annum, then the signs for the US economy and therefore its equity market look very good.
“However, the bond markets are telling a different story,” Stephens continued.
“These have been very strong which is counterintuitive when one would be expecting economic strength to lead to interest rate rises. This has also been the driving force behind the strength in the dollar and so why are bonds not weak?”
He says the reason why US 10-year treasury yields have rallied to just 1.89 per cent is due to external factors such as the fall in commodity prices, weaker economic growth elsewhere in the world and the threat of deflation in other developed economies.
“The significant fall in commodity prices over the last year has been a dampening effect on inflation but does not affect the consumer price inflation [CPI] numbers as this is significantly based on a consumer shopping basket of goods and not input costs to industry,” he explained.
“However, the 50 per cent fall in the oil price affects the consumer more significantly in terms of a boost to discretionary spending every time they fill up their car and that is more influential to the CPI.”
Our data shows that due to oversupply issues and as the OPEC nations didn’t step in to manage the market, the S&P GSCI Brent Crude Spot index has fallen by more than 40 per cent over three months, leaving the oil price at just $45 a barrel.
Performance of indices over 3 months
Source: FE Analytics
Stephens says the lower oil price has not started to affect the inflation numbers yet, but will do over the coming few months and as OPEC is still refusing to cut supply, it will continue to put pressure on the CPI for some time to come.
He also points out that the rally in US treasuries is also a reflection of the concerns about inflation in Europe, which according to a flash estimate by European Union statistical office Eurostat moved into negative territory in December.
“The mindset of ever-decreasing prices leading to delayed consumer spending is not yet engrained and Europe is not in a Japan-type stagnation scenario yet,” Stephens explained.
On top of that, FE Trustnet reported earlier today that inflation in the UK has fallen to just 0.5 per cent. However, Stephens says the eurozone will continue to be the main sources of bad news for markets for the time being as political risks mount.
“We know there is trouble ahead with the Greek vote and a likely head-on confrontation with the Syriza anti-austerity party, Angela Merkel and the ECB, which may explain why the equity bulls are currently subdued.”
“European QE is being seen as a certainty but this involves the buying of sovereign debt of troubled countries. Greece’s problem is the size of its government debt pile compared to its national income. If they are about to have the opportunity to offload some of this to the ECB, a confrontational anti-austerity approach is probably not the best negotiating strategy.”
“This is also the most likely reason that Angela Merkel has already said that the EU can deal with a Greek exit if that is what they want.”
Stephens says he can’t accurately predict which of the two asset classes is “correct” in the current market. He is backing equities, but says there are risks involved in buying them at the moment.
“The US economic machine is thankfully firing on all cylinders but any signs of weakness would affect the equity market. The Q4 results season starts today which should be strong if the GDP figures are a useful guide. The equity market is very reliant on this at the moment as the rest of the world struggles on,” Stephens said.
He added: “On balance, we continue to back earnings strength and equities for the medium term but shorter term, there is a lot to take on the chin.”
Given that uncertainty, in an article later this week FE Trustnet will look at the mixed assets funds which have delivered returns which are lowly correlated to both equity and bond markets.