Our Blog
The relationship of bonds and equity markets

After an extremely strong run, both bond and equity markets have had a bit of a wobble recently.

The fact that both markets have wobbled at the same time is no coincidence.

Historically, the two markets have often gone in different directions. When investors are worried about the future they tend to buy government bonds, which are perceived safe havens. When they are more optimistic they sell those bonds and buy equities.

However, since the 2008 financial crisis these asset classes have often moved in the same direction. Central banks have cut interest rates to near zero and pumped money into the system via quantitative easing, which has proved beneficial to bond and stockmarkets.

What we have seen over the past few years is that sometimes bonds are still negatively correlated to stocks, but sometimes they are positively correlated. This makes it difficult to create a diversified portfolio where traditionally bonds are used to offset equity risk. Sometimes bonds are providing the diversification they are meant to, and sometimes they are actually adding to the risk.

Since December 2016 the Federal Reserve has increased interest rates three times. Normally this tends to mean bond yields rise (as capital values fall) but in fact they have remained relatively stable. This is partly because other central banks in Europe and Japan have been continuing to do quantitative easing. This has kept global bond yields low.

However, more recently central banks around the world have started hinting at withdrawal of stimulus whether that is slowing QE (Europe), raising interest rates (Bank of England), or even potentially reversing QE (US). This has led to a short, sharp sell off in bonds which has also had a knock on effect to stocks.

So why did stocks also sell off? Well there are several ways in which the markets are linked but there is one way in particular which affects certain companies and markets more than others.

One traditional way of valuing a company’s shares is to use a “discount cash flow model”. This simply states that a company’s share price is merely a function of all future cash flows (the income or profits received by the company). However, since a pound in the pocket now is worth more than a pound in the pocket in the future, you need to apply a “discount rate” to future cash flows.

For example, if interest rates are 1% then receiving £101 in a year’s time is worth the same as receiving £100 today.

Analysts traditionally use bond yields as the discount rate rather than short term interest rates. If bond yields go up from 1% to 2%, then £100 today is now the same as £102 next year. Therefore, the discount rate used to value future profits has increased, meaning the value of those future profits is reduced.

Using this way of valuing a share, those companies which are expected to grow their profits quickly can currently justify very high share prices, since interest rates and bond yields remain close to historic lows. However, a relatively small change in yield can change this valuation dramatically.

For now, bonds appear to have stabilised. However, if monetary stimulus is withdrawn too quickly then yields would likely rise quite sharply. In this scenario stockmarkets would likely sell off too, with the highest impact on those more “expensive” stocks and markets.

In our view, this risk is not merely a reason to be underweight government bonds, but also to favour the cheaper stockmarkets in Asia over those in the US and Europe, which in our opinion look quite fully valued.

 

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. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.