Bond or equities: Which market has the more realistic view?
Bond and equity markets are telling very different stories about the state of economic growth: Which is right?
- Equity market earnings growth assumptions directly contradict the economic outlook implied by 10-year government bond yields
- The withdrawal of QE and rising rates may expose bond or equity markets
- Equity markets assumptions look less unrealistic than those in the bond market
Is it possible to reconcile the apparently conflicting views of the bond market and the equity market? On the one hand, the bond market is suggesting low economic growth is likely to endure for some time, while the equity market is expecting buoyant earnings growth well into the future.
Peter Toogood, chief investment officer at the Adviser Centre, said in a recent note that this was his key concern: “10-year bond yields from the US to Europe and Asia are currently implying very low levels of economic growth in the future. At the same time, the price earnings multiples of equity markets make heroic assumptions about earnings growth, which directly contradicts the economic outlook anticipated by 10-year bonds!”
In some ways, it is perhaps not entirely unexpected that the bond and equity market should be rising at the same time. All markets are subject to fund flows, and quantitative easing continues to create liquidity. The worry is what happens when it disappears. Rates are already rising in the US, while the EU may start to pare back its programme later this year.
This may expose financial markets and investors will need to decide which market has the more realistic view of the world. Certainly, there are reasons to support the bond market’s view of the world. Inflation is still low in spite of high employment levels. The Federal Reserve suggested that inflation should pick up once unemployment fell to levels of around 4.7%. It is far lower, and inflation has still not risen.
There are still significant deflationary forces at work: technology and automation are driving costs lower, while governments across the globe have huge debt mountains to navigate. These factors are keeping a lid on growth. The narrowing gap between shorter-term and longer-term rates is also important – it shows the bond market believes the economy isn’t strong enough to withstand rate rises.
The optimism of the equity market has been supported by stronger economic data. Valuations may be high, but earnings have been good as well. With inflation low, it is easier to generate stronger earnings and this, to some extent, justifies higher valuations. However, there remains a question over the extent to which the equity market has discounted Trump’s failure to implement tax cuts.
Which market is right? Valuations in both markets are near all-time highs, but the bond market’s interpretation, with its associated valuation levels, looks less realistic. Most still expect yields to rise from here, except where there are unique circumstances (such as the UK). That is not to say that the equity market interpretation is particularly realistic either, but investors have to go somewhere.