All things must pass. Treasury bonds, regarded as the world’s safest assets, have been in a “bull” market (meaning their prices have risen while their yields have fallen) since 1982. Equities have been in a secular bear market (with falling prices) since 2000. Neither can last forever. It is possible that in future we will see that both have already ended.
This week saw prominent calls that both markets have turned. Let us start with bonds. After 30 years when the “risk-free” cost of money has steadily declined, a reversal of this assumption would be important indeed.
Mansoor Mohi-uddin of UBS made exactly that call this week, saying “this era is now set to end”. His case is as follows: “The Federal Reserve will not undertake another round of quantitative easing, the US economy shifts to a sustainable recovery, private sector credit in the US expands, China and other major emerging economies rebound after dipping in the first half of 2012, and the eurozone recession doesn’t shock the global economy.”
If all of these conditions are confirmed, then a bond bear market, with lower prices and higher yields, is inevitable. And note that such a prediction can be made without even referring to concerns about US creditworthiness.
But none of these conditions is yet certain. There are still nagging fears that the US economic strength so far this year has been down to tax incentives favouring business investment, which have now expired, and to unseasonably warm weather. Markets suffered collywobbles this week over downbeat data from China; and more ugly shocks from the eurozone remain a clear possibility. Greek bonds, after their great “bailout” of a few weeks ago, now yield more than 20 per cent.
But let’s assume that bonds are indeed in a new bear market. How will this affect equities? It should be good. Money coming out of bonds must go somewhere. As investors will be optimistic about the economy, it should go into stocks. As the chart shows, UK pension funds have made a huge switch from stocks to bonds in the past 20 years (and broadly similar patterns can be seen elsewhere). Reversing that would be good for stocks. And at the retail level, it is interesting that Emerging Portfolio Fund Research noted the biggest outflow from bond funds on record this week.
However, this week saw much attention for a bold call by Peter Oppenheimer that it is time for a “long goodbye” to bonds and a “long good buy” for equities. It met with initial cynicism, probably because he works for Goldman Sachs, who have a credibility problem these days. But his argument, spelt out in great detail, deserves attention.
Much of it accurately glosses research showing that equities outperform in the long term, and that long bull markets tend to start when equities are very cheap, rather than when the economy is strong. Mr Oppenheimer then argues that equities are cheap relative to bonds. As bonds now offer a lower yield than many stocks pay in dividends, this is true in a sense.
The crucial argument against this position, to quote Mr Oppenheimer himself, is that “equities only look attractive because bonds are overvalued, and their yields are unsustainably low. If bond yields were to rise, so the argument goes, then equities may outperform in relative space but wouldn’t rise in absolute terms.”
This is indeed a good argument against his position. And his main response is a good one. He argues that the correlation between rising bond yields and equity prices is not constant, but changes according to the level of the yields. When yields are low, a rising yield does little damage to the economy or to companies’ borrowing plans. But above a tipping point of about 4 per cent or 5 per cent, higher bond yields begin to entice investors away from stocks, and push up the price of borrowing for companies – all very damaging for equities.
With yields starting out at historic lows, plainly an initial move would be positive for stocks.
Ten-year treasury bonds currently yield 2.2 per cent. They could rise for quite a while before troubling the stock market.
Where does this leave us? A turn in bonds would initially be great for stocks, which would take in the money displaced. This big switch has not yet started and at some point in this decade both equities and bonds will shift their secular direction – probably at much the same time. The critical driver is the economy.
However, the economic data does not yet prove that the secular shift is imminent. And once the shift has happened, equity investors need to be very careful that bond yields do not race upwards, raising the cost of money and crimping the valuations they can pay for equities. Almost every bond trader working today has only known a world in which yields forever come down, so there is a real danger that this could happen, if and when it becomes clear that bonds’ long bull market is over.
Get alerts on Markets when a new story is published