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The equity-bond battle: Which market is right?

by Eleanor Lawrie on May 28, 2014 at 15:17

The equity-bond battle: Which market is right?

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.’

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