Squaring the Circle – bonds and equities cant both be right

While I was on holidays in Fiji recently I read a book about the Archimedes Palimpsest which was my first real exposure to the study of Archimedean and Greek mathematics outside of school. It really was fascinating but in the context of markets and the economy I was struck by the quote attributed to him about leverage:

“Give me a place to stand on, and I will move the Earth.” (Greek: δῶς μοι πᾶ στῶ καὶ τὰν γᾶν κινάσω)[35

It is clear to me that in today’s context, the lever to move the world, or should I say equity markets, is free money. Sure, central banks don’t have a choice when the new orthodoxy is for governments to pursue austerity with great fury but it’s also expressly meant to lever the stock markets of the globe out of their doldrums.

Clearly this strategy has worked and equities, notwithstanding last night’s performance, have been making fresh multi year highs recently – the Australian market even snuck above 4000. But the bond markets are telling us a very different story about the outlook for the economy and it seems a difficult circle to square when bonds are pointing to enduring economic weakness but equities seem more aligned with an economic bounce.

So who’s right, bonds or equities?

This is the question that springs to mind in the post GFC world. Now it’s important to note that I don’t mean that the GFC is over but rather that the economic outlook for the globe is structurally very different now after the events of 2007/08/09 it’s just that I don’t know what to call it. New Normal doesn’t seem to fit, post GFC seems to assume it’s over and clearly it’s not. I quite like The Prince’s name for it: The Great Volatility.

Anyway, the chart below is of the medium term relationship between bonds and equities in the US. We’ve used the US 10 year Treasury and the S&P 500 as our proxies here and you can see that they usually follow a similar path – or at least they have for the past 15 years.

This of course makes perfect sense. Good economic performance and equities rally on expected greater earnings and sales while bonds sell off (yields rise) on the prospect of this increased economic activity and both selling from bond holders to move into equities to avail themselves of the greater capital gain opportunities, as well as the expected increase in yields from the Fed. I’m comfortable that in a broad sense I can see both the correlation and importantly the causality for why this relationship should hold.

Now, I should make it clear that I am an interest rate and currency guy not an equity guy. I think this has a certain impact on the way I view the world, or perhaps I am an interest rate and currency guy because of this view. Let me explain – in a broad sense, bond guys are usually more interested not with the return ON their money but the return OF their money. So we tend to see the black clouds, indeed we are trained to see black clouds because as bond holders when the black clouds come and interest rates rally (fall) we make capital gains as the value of our bonds appreciates.

Equity guys and girls are for the most part fitted with a different DNA – they are concerned with the return ON their money – they want capital gains, they want the economy to be doing well. They want to see not the clouds but the blue sky, they generally believe that in the long run equities always go up. As a group I reckon they are just generally more optimistic.

So where are we at the moment and who is right? Are bond markets seeing the future of a low growth environment right or are the equity guys right in expecting that things will be getting better soon and the move out of the secular bear to a secular bull is afoot.

Unsurprisingly I’m in the camp that says the bonds guys are right. But, I recognise equally that Archimedes principal on leverage is being used by the Fed and its central bank cohort to lift equities and they hope to create optimism and drag the real economy and main street along for the ride eventually. How this lever works is fairly simple – in keeping rates at or near zero the discount rate of any future set of cash flows is zero, or close to it, which means the net present value of those cash flows is huge. Just like the Australian dollar benefits from the carry trade, so central bankers in the developed world are encouraging the biggest carry trade in the history of the world – rates at zero so buy equities.

It’s working at the moment – but is it possible for this dichotomy between the outlook from bonds and equities to be sustained? It is an increasingly important question to answer for Australian investors because the same dichotomy is suddenly developing at home:

Historically in Australia, the same correlation between stocks and bonds is apparent but less strongly so until the mid part of the last decade. Since then, in a world of highly correlated global markets, the relationship is stronger and so the same question can asked of the Australian market as the US market.  Can the divergence persist?

Have a great day

Greg McKenna

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