The FTSE recently hit a 14-year high, as gilt yields approach recent lows. This was not an isolated correlation: in both Germany and the US yields have tumbled as equity markets set records.
This is far from the first time bond and equity prices have either fallen or soared in tandem in recent years. The move should also not blind us to the fact that such seemingly coordinated moves rarely last long and inevitably end badly for one asset class. So which will blink first?
‘You have two camps of investors: some are risk-on, and some are risk-off, and we have a central bank backdrop that supports that,’ said David Lebovitz, market analyst at JP Morgan.
‘On the other hand, you have some people who say “the world is getting better, I’m buying into equity markets”, and then you have investors who think “well, it could get rocky but monetary policy is easy so I will go for bonds”.’
A correction due
The end result of this, the analyst said, is that one of the markets is liable for correction, and in this case he thinks bond prices are set to fall as investor confidence increases.
‘They are not both sustainable. I personally think the fixed income markets are mispriced,’ he said.
‘If you look at equity valuations, they seem fair value on a price-to-earnings basis. Bond markets are looking very expensive relative to equities.’
When bonds get more expensive, it usually signals an increase in investor caution, as fixed income is considered to be a safer place to allocate money to than equities.
To some extent, easy monetary policy has derailed that past assumption. But the fact easy monetary policy is still the primary market mover, even as central banks attempt to wean investors away from support, is an important factor for RMG Wealth’s chief investment officer Stewart Richardson (pictured). He said the simultaneous rise was because the equity market was ‘strenuously overvalued and arguably in a bubble comparable to 2007 and 2000’.
‘What currently has our short-term attention is that bonds are absolutely not pricing in 3%-plus growth for the rest of the year, whereas the equity market seems to be priced for perfection,’ he added. ‘One of these markets is wrongly priced. We are currently in a low growth, high liquidity environment which cannot last forever.’
The logical response to the situation was for investors to rid themselves of some of those overpriced equity holdings. ‘Simply put, now does not appear to be an appropriate time to be holding on to equity exposure, let alone buying more.’
Limited valuation support
David Vickers, senior portfolio manager on Russell Investments’ flagship £1.2 billion Multi Asset Growth Strategy fund, is also more cautious on equities compared with a year ago. ‘In the equity market, there is not much valuation support, but the risk premium is a little elevated. We have seen peak earnings and peak valuations, and if you are at the higher end of the spectrum the probability of a fall is substantial.’
To counteract a potential drop, Vickers has bought put protection in the fund, which means equity markets could fall as much as 12%, and his portfolio would behave as if it had less than 10% in equities.
Despite this defensive measure, he thinks equities will outstrip bonds this year, but is reassured by low default rates so expects some areas of fixed income to provide a more dependable return.
‘We believe equities will outperform fixed income but we are not going into a recession anytime soon. Europe is getting better and for the first time since 2012, the G3 economies are all pushing in the right direction. Default rates will continue to be low, and in a world of low returns I have a higher conviction that I can get 5% from loans and high yield than 7% from equities.’
Clearly this simultaneous rise cannot go on forever, and which asset class you favour going forward will depend on your world view, and predictions of what central bankers will do next.
However, as David Lebovitz observed: ‘It’s the unforeseen shocks that rattle markets the most.’ In such a contradictory environment, investors need to consider how to protect themselves from a correction in either market, which will mean a degree of diversification.