A current theme of analysts' conversations is the apparently contradictory message that the recent ...
A current theme of analysts' conversations is the apparently contradictory message that the recent rally in both equities and government bonds appears to be giving.
In May the MSCI US index rose 5.3%, while the 10 year Treasury yield fell 49 basis points to a near 40 year low of 3.4%. These numbers suggest that currently optimistic US earnings growth forecasts are not at risk, despite the current era of very weak pricing power, while the bond market indicates little or no domestic or global growth and the risk of deflation. With positive returns on both bond and stock markets in most major financial centres, this message has become global.
How can these two interpretations both be right? After all, low growth and deflation caused by weak demand (the bad sort of deflation, and the sort we are at risk of) do not suggest all is well for corporate earnings growth.
Yet this is to misinterpret the bond and equity markets. Declining yields do not necessarily imply growing pessimism on the growth outlook, but more confidence that rising inflation will not be a threat within the context of improved growth expectations, which will be supportive of earnings and stock markets.
After all, in the 1990s yields fell while stock markets boomed as policy changes ' such as central bank independence in Europe-helped tackle inflation.
Following the Fed's assurances in May that it is conscious of what Greenspan has called the threat of 'corrosive' deflation, it is likely that for the remainder of the year central banks, including the ECB, will fight tooth and nail to ensure a lax enough monetary policy to deliver global growth. Fears of interest rate increases later in the year, as the US economic growth cycle picks up, have been shelved.
So, temporarily, everyone is happy. Bond markets are relieved that the Fed sees no threat of inflation, while equities take heart from the Fed's promise to do everything possible to avoid deflation (ie, to stimulate demand). Greenspan has satisfied both camps.
But with fiscal and monetary policy being aimed at stimulating growth and avoiding deflation, in the longer term it is the bond market that is at most risk of being proved wrong. This does not mean that equities will necessarily continue to rally; there are enough concerns over earnings prospects and P/E valuations in the US and Continental Europe to keep stock markets capped even if bonds do finally weaken.
But bonds appear to be the more exposed of the two asset classes, given the determination of the Fed to avoid deflation (and therefore a willingness to take greater risks over inflation) together with the issue of over-supply as the western governments increase their borrowing to pay for greater fiscal spending.
As things currently stand, it would take a brave investor to bet against the prospect of a pick-up in global growth over the next 12 months, and to favour bonds at the expense of equities.
Lax monetary policy to aid growth.
The Fed will not rush to raise rates.
Fed will be supporting demand and growth.
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