Has the rule book on alternating between equities and bonds been rewritten by investors?
Conventional financial wisdom suggests that investors alternate between equities (risky) and bond (safer) depending on the mood prevailing in the markets. When the going is good, the investment community becomes elated (a ‘risk-on’ mood) and equities, along with other riskier yet higher yielding assets, rally. Conversely, in bad times, the money is pulled out of equities and moved into bonds. Hence, bonds tend to rally in periods when ‘risk-off’ sentiments prevail, while equities underperform.
However, this relationship seems to have broken down in recent times, especially since the 2008 credit crisis. Since the beginning of 2009 for example, the FTSE 100 index has returned circa 130% while longer dated British government bonds have seen close to 100% returns. Needless to say, investors in both of these asset classes have amassed fantastic returns, so let’s examine how this has been possible.
The most important factor has been the liquidity in the system. Central Banks across all of the developed markets had been pumping billions of pounds and dollars into the financial system in order to combat the credit crunch. This was effected by buying of government (and corporate) bonds from the market, which in turn pushed the bond yields to historic lows and consequently the prices up.
As illustrated in the above chart, the 10 year British government bond yield (which is the annual return on holding the bond until it matures) has moved down from over 12% in the early 1990s to around 1% currently. Central banks have of course consistently cut their policy rates to rejuvenate economies reeling from the credit crisis and kept them low in the past 10 years. Recently, the Bank of England had cut its bank rate to 0.25% in an attempt to combat any adverse impact of Brexit while Central Banks in some developed economies, like the Eurozone and Japan, have flirted with negative interest rates.
Consequently, bond prices were pumped up and equity markets rallied as the excess liquidity in the system flowed into the riskier asset classes. Share buybacks and dividend payouts were part of the key themes that drove asset prices, as corporates failed to identify opportunities for business expansion and preferred to return capital to shareholders. As a result, the growth in corporate earnings could not keep pace with equity prices, causing equities to trade at valuations which are ahead of (or quite in line with) the highs scaled during the peak of the 2007-08 bull market.
What can halt the juggernaut?
Experts regularly call market peaks, and stories of an impending US recession were regularly floated over the past couple of years. Some of the major developed economies are still tottering due to the effects of the financial crisis. The UK itself is facing uncertainties over Brexit negotiations and outcomes, together with a slim and new coalition government. But what does this all mean for us investors? Will any of these events bring a correction to the high asset prices?
Over the past twelve months, a lot of black swan events have tested the markets, and the market has taken each one of them in its stride and moved to record highs. The list is long, with global geopolitical events like Brexit, European and US elections, concerns regarding the stability of the Chinese economy and a meltdown in oil prices among others. While this could be a classic sign of exuberance that fuels bull markets, we believe that taking a call on the immediate market movements could be short-sighted.
Rather, a closer look at macro-economic developments could provide valuable clues regarding longer term asset performance. While not yet firing on all cylinders, the latest macro-economic data in the UK has been optimistic, and the US economy is showing signs of a recovery in corporate earnings. Inflation has moved up in recent times across developed economies. While all this may point towards satisfactory asset performances over longer periods, we investors need to keep a close watch on how these indicators evolve over the coming months, particularly as the Brexit countdown is underway. The results of the negotiations will undoubtedly impact the long term performance and associated risks of the UK economy and consequently that of UK-based investible assets. Being able to correctly identify what that impact is likely to be will be critical for the performance of investor portfolios.