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The great chasm

26 September 2019

Equity and bond investors have arrived at two very different conclusions about the outlook for the global economy. GAM Investments’ Julian Howard explains why this chasm deserves special consideration from investors.

Veteran investor Robert Shiller once said “There’s so much disagreement about investing, and it’s because nobody really knows.” Today, disagreement appears to be particularly stark, with equity and bond investors divided about the future prospects of the world economy. Taking the US for the sake of simplicity, the S&P 500 has climbed 18.3% this year to 30 August, while the 10-year US Treasury yield has fallen from 2.7% to 1.5%, close to an all-time low. Equities and bond yields are often seen as sentiment indicators and as such, they usually move in tandem. Equities represent the price that investors are prepared to pay for the future earnings streams of corporations, which is heavily influenced by economic growth expectations. Government bond yields should be a function of economic growth and inflation. The fact that these two asset classes have arrived at two entirely different conclusions about the health of the world economy is therefore unusual and demands urgent consideration by investors.

Separate ways - equities and bond yields fall out spectacularly

Source: Bloomberg. For illustrative purposes only.

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

At the heart of this estrangement is the US-China trade war and the uncertainty it is creating around the world. Bond investors feel that growth is threatened by trade disputes which hurt global export volumes. And with low growth, it is unlikely that there will be any inflation since worldwide capacity will be under-utilised. This pessimism manifests itself in falling interest rates of all maturities. Short-term rates fall because of central bank intervention to loosen monetary policy while long-term rates fall due to lower assessments of future growth and inflation. There is another mechanism too, in that many investors with a choice of assets before them jump into the perceived ‘safety’ of government bonds during periods of uncertainty. But if too many do this – as has happened – the net result is exorbitantly high bond prices and near-historical low yields. Hence the Austrian 100-year bond issued in 2017 has nearly doubled in price to 30 August this year alone (who said bonds were boring?). Now the Austrian government plans to issue another ‘century’ bond offering a yield of just 1.2%. Incredibly, it is likely to be taken up, since many investors such as pension funds have little alternative to buying predictable assets in order to manage their long-term liabilities.

For equity investors, concerns about the global economic outlook are noted but seemingly ignored, with the S&P 500 barely 3% off its July all time high as at 30 August this year. What do they know that bond investors do not? Perhaps one legitimate factor that the bond market is overlooking is the recent primacy of services in the world’s largest economy, the US. In the 20th century, a significant proportion of American recessions were prompted by manufacturing slowdowns or energy shocks and commentators continue to focus on these. But manufacturing now represents less than 12% of that economy, while its energy intensity of output has been steadily falling as the economy shifts to services and consumption. Therefore, while the trade war rightly sends shudders through exporting economies such as China, Germany and Japan which are closely integrated into the global supply chain, the reality is that the world’s largest economy should better withstand it given its relatively closed nature and large self-sustaining population. Unsurprising then, that the global equity market – dominated by the US – has exhibited remarkably low volatility so far this year.

Limits to the pessimism – consumer a major contributor to the US economy

Source: Bureau of Economic Analysis, GAM. For illustrative purposes only.

There is another, more nuanced accounting mechanism at work here which can reconcile the robust equity market with plunging interest rates. Lower interest rates of all maturities are barely discounting the net present value of the future earnings streams of publicly listed companies. In the eyes of equity investors, this increases the value of those earnings even as their growth slows around the world, including the US. And the even better news is that central banks are becoming more responsive than ever. In a world of low growth amid challenging demographics and a growing intolerance of the human cost of economic recessions, central banks are now doing all they can to boost their economies ahead of time rather than after the event. A notable example in recent weeks has been the New Zealand central bank which cut interest rates by half a percent even though the bank itself admitted that the economy was enjoying an 11-year low in unemployment and rising wages. Today, the mere possibility of a future slowdown elicits an aggressive monetary policy response which, as described, has different effects on equities and bonds. Just as central bank intervention lifts equities so too does it suppress bond yields as it drags short-term interest rates down and appears to confirm bond investors’ fears about long-term growth and inflation. And so the circle is squared.

In any investment assessment, pessimists tend to come across as more informed, as if they have carefully weighed and measured the odds, while optimists naturally tend to sound reckless and less concerned with the facts. Looking at today’s divergence between equities and bond yields, the former’s resilience in the face of the sheer cacophony of noise and around the trade war and geopolitics could be interpreted as wilful indifference, while bond markets might appear to be making the ‘correct’ moves in response to fears about the future. But while it is true that equity investors are a naturally more optimistic bunch – after all you have to believe in human progress and innovation to invest for the long term – there are valid structural and economic reasons for their optimism which the bond market appears to be overlooking this time. And the extent to which short and long-term interest rates worldwide have fallen is also a significant support. It is often said that we are all prisoners of our experience and for many market veterans today’s situation is downright wrong and something will have to give. But slow and steady growth, accompanied by minimal inflation and a newly activist monetary policy response, could be solid groundings for stable equity markets despite all the geoeconomic uncertainty. Investors may find that the chasm stays so for some time and that – surprisingly – they need not worry too much.

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. Reference to a security is not a recommendation to buy or sell that security.