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Economic forecasting

Anyone looking at the stockmarket right now would probably make the assumption that the economic future looked pretty rosy.

Stockmarkets look pretty expensive on most measures. One of our favoured measures looks at the price of stocks relative to company profits. This is known as the price/earnings ratio.

As I write, the price/earnings ratio of the UK stockmarket is around 22. That means the average price of shares is 22 times the profits made by the companies. The long term average is around 14 times earnings, so this is much higher than it has been most of the time in the past.

In the US, the ratio is over 23 times earnings, compared to a long run average of around 16.

One reading of this is that investors are expecting earnings to grow quite quickly. A company where profits are growing rapidly usually has a high price relative to current earnings. As the earnings are likely to be a lot higher next year than they are now, this justifies a higher price now. Of course, this all depends on whether that expected earnings growth comes through.

The high ratios of the markets therefore imply that the profits and therefore (by implication) the economy is likely to carry on growing at a decent pace.

However, bond markets are telling a different story.

What does the bond market tell us?

By looking at the price of government bonds such as UK gilts or US Treasuries, we can work out what investors are expecting interest rates to be in the future. These bonds are guaranteed by their respective governments and so there is little chance of default. Their prices are therefore mainly set by interest rate expectations.

There is usually a “term premium” for longer term bonds. If you lend your money to the UK government for 10 years you’d expect a better rate of interest than you would if you bought a two year bond, just like if you were considering a fixed term bank account.

Chart 1 shows the current “yield curve” on the UK market. The black line shows the different yields for different maturities of bonds at present. Generally, the longer dated the bond the higher the yield:

chart1.png

A 10 year gilt currently yields around 1% pa. That’s quite a long way below where it was a year ago (blue line on the chart). Interest rates are currently 0.25% so bond market investors are not expecting this to rise very much over the next decade.

The Bank of England principally uses interest rates to try to control high inflation, which often results from high economic growth. The bond market is therefore pricing in very little inflation, implying low levels of growth too.

Recession indicator

The bond market has historically been a good recession indicator.

Usually, longer dated bonds yield more than shorter dated bonds, however that’s not always the case. If short dated bonds yield more than longer dated bonds it’s called an “inverted yield curve” – in other words it slopes in the opposite way to the one above.

An inverted yield curve tells us that bond markets are expecting interest rates in the future to be lower than current rates. In other words, they imply that the economy will slow down.

Investors often look at this indicator by taking the yield on a 10 year bond and subtracting the yield on a two year bond. Chart 2 shows how the US version indicator has changed over the past 30 years. The grey shaded areas are recessions.

chart2.png

This indicator has turned negative before each of the past recessions, with one false result.

What you can also see from the chart is that this indicator is pretty much as low as it has been at any time since the financial crisis, although it is still positive.

The US economy is currently doing pretty well, and the Federal Reserve is gradually increasing interest rates. That is pushing up short dated bond yields. However, long dated bond yields have actually been falling of late. The bond market therefore isn’t nearly as optimistic as the stockmarket, although it is not currently implying a recession.

After Donald Trump’s election there was a brief period where growth expectations rose, based on his promises of infrastructure spending and tax cuts. These look much less likely, or at least are likely to be smaller than promised, and so growth expectations are being cut. However, the stockmarket doesn’t seem to have cottoned on to this yet.

In our experience, if the bond market tells us a different story to the stockmarket, it’s best to listen. Historically, the bond market has often been right.

 

The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice.