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The Bull Necessities: can equities extend their rally?

13 June 2019

With the US economic expansion nearly 10 years old, investors are increasingly concerned about the longevity of the expansion and the outlook for risky assets. GAM Investments’ Michael Biggs examines the macro backdrop and concludes that investors should continue to hold both equities and government bonds.

The US economy is well into its 10th year of expansion and by most measures the S&P 500 index is now enjoying one of its longest bull markets on record. Valuations appear stretched and investors are naturally concerned about the possibility of a sharp pullback. We have enjoyed the market’s ride into the sunlit uplands, but no one wants to be left holding risky assets if the market tips into the abyss. Traditional safe assets also appear less attractive – in recent months US treasuries have rallied, and 10-year yields are now back close to 2%. What is an investor to do?

We believe that in the current macroeconomic environment, investors should continue to hold both equities and bonds. The argument is based on three crucial relationships.

Chart 1: US New borrowing

Source: Haver Analytics, as at 11 June 2019

Chart 2: The credit impulse and demand

Source: Haver Analytics, as at 11 June 2019

The first of these is the relationship between credit and the business cycle. During the expansion phase of the cycle, new borrowing rises, the credit impulse is positive and real domestic demand growth is strong. In time, new borrowing levels become elevated and a shock of some sort (perhaps an interest rate hike) causes new borrowing to fall, the credit impulse to go sharply negative and the economy to fall into recession.

The risk of a recession increases when new borrowing levels are high. Before each of the previous recessions going back at least to 1970 (chart 1), new borrowing levels were well over 10% of GDP and it did not require much of a shock for new borrowing to fall. In contrast, current levels of new borrowing are around 6% of GDP. It is much harder for new borrowing to fall from these levels and, in our view, this makes a recession unlikely in the near term.

The implications of this growth outlook for asset prices are captured in our second relationship – that between the Institute for Supply Management’s (ISM) purchasing managers index and year-on-year returns to the S&P, as shown in chart 3. While this correlation holds, decent growth is a sufficient condition for positive equity returns. If we are correct in our view that a US recession is unlikely, then the ISM should in general remain above 50 and returns to equities should remain positive. In this context, we believe a bearish view on equities should only be necessary if growth is expected to slow and the ISM falls sustainably below 50.

Chart 3: Correlation between the ISM purchasing managers index and year-on-year returns to the S&P 500

Source: Haver Analytics and Bloomberg, as at 11 June 2019

Past performance is not an indicator of future performance and current or future trends.


Equities and growth have not always moved together, and in the two decades before 2000 the correlation between the ISM and equities was around zero. What has changed? The answer to this question might lie in our third important relationship – the correlation between bond and equity returns. This correlation was positive from 1965 to 2000, but has turned negative since then (chart 4).

Chart 4: 5 year correlation between bond and equity returns (S&P 500 and US 10-year)

Source: Bloomberg, as at 11 June 2019, based on S&P 500 and US 10-year treasuries

Past performance is not an indicator of future performance and current or future trends.


In our view this correlation depends on the concerns of central banks. When central banks are worried about inflation (1965-2000), bond and equity returns have been positively correlated. An increase in inflation causes central banks to hike rates and bonds to sell off, while the weaker growth outlook causes equities to decline. When central banks are more worried about growth (2000-2019), the correlation tends to be negative. Weaker growth causes equities to fall, but central banks often respond by cutting rates and bonds rally as a result.

This observation is important in its own right. If the correlation of returns between bonds and equities is negative, the volatility of a portfolio holding both asset classes declines. An investor should be willing to pay a higher price for such a lower volatility portfolio and valuations for both bonds and equities should increase. An analysis of asset price valuations that does not take this correlation into account will tend to find that assets are expensive, even if they are not.

The observation also has important implications for our ISM / S&P relationship, because the tight correlation between the ISM and S&P has only held while the correlation between equity and bond returns has been negative. Or, to put it differently, positive GDP growth is only correlated with positive equity returns when central banks are not too concerned by inflation.

This is intuitive. If GDP growth strengthens, nominal earnings expectations should on average be revised up. If the central bank is unconcerned about inflation and hikes rates only modestly, then we believe earnings expectations could rise by more than equity valuations fall and equity prices will increase. The ISM and S&P will display the positive correlation we have seen so far this century. If, in contrast, the central bank responds by hiking rates aggressively due to inflation fears, then equity prices could fall even as yields rise, and the relationship between the ISM and S&P could actually turn negative.

In the absence of inflation, good growth is good for equities. If we are correct in our view that current low levels of new borrowing make a US recession unlikely, the ISM should remain above 50 and equities should rally. In our view, the negative correlation between equities and bonds means that bonds provide an excellent hedge to these equity holdings if we are wrong and growth surprises negatively. As a result, we believe investors should continue to hold both bonds and equities. Losing 1% on bond holdings is easier to stomach if these losses are likely to be more than made up by gains on equities.

The big risk to this view, of course, is a sustained rise in inflation. If central banks become concerned about inflation, then the correlation between equity and bonds returns could turn positive again, the ISM / S&P relationship could break down and equities could fall even if growth is fine. While we see little evidence of inflation at present, there are good reasons to be concerned about this risk in the medium term.

Chart 5: The US budget deficit and unemployment

Source: Haver Analytics, as at 11 June 2019

Chart 6: Core CPI Inflation

Source: Haver Analytics, as at 11 June 2019

Chart 5 shows the relationship between the US budget deficit and the unemployment rate. In normal cycles the two are positively correlated – recessions cause unemployment to increase and the government responds with fiscal stimulus in an attempt to kick start a recovery. As the economy recovers, unemployment declines and the budget deficit narrows.

In this cycle, in contrast, the US has put in place a fiscal stimulus even though unemployment rates are low and falling. The last time this occurred was in the late 1960s and, as chart 6 shows, this coincided with a sharp rise in core inflation. The pick-up in inflation happened before the oil price increases of the 1970s.

We should be cautious about confusing correlation with causality and we believe it is difficult to gauge the extent to which this inflation was driven by fiscal stimulus. It seems reasonable, however, to assume that such a boost to demand could cause inflation when an economy is operating at full employment. If this occurs, then both bonds and equities could sell off sharply. This risk appears low at present, but we should be ready to change our views if inflation takes hold.


Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.