New article from Tatton Investment Management: Bond markets unnerve equity markets - again

11 August 2019

We have repeatedly commented on these pages that the good mood in asset markets this year is more to do with central bank policy than a positive backdrop of the real economy. With poor economic fundamentals, central banks will pump liquidity into the financial system, supporting both bonds and equities. As the asset class returns table for July illustrates (see further down), this trend continued into the summer and all those who followed the old UK investment adage of ‘sell in May and go away, don’t come back till St. Legers day’ would have missed out considerably.

However, the first full week of August provided a timely reminder that current stock market levels are not well supported by economic growth prospects, making them even more vulnerable to shifting investor sentiment. This time, the souring of sentiment was once again caused by the Trump administration, when they announced another round of tariff increases after the ongoing trade negotiations hit a renewed impasse. China’s apparent retaliation then exacerbated the trade scare story, as they allowed their currency to drift lower – offsetting the cost burden introduced  by tariffs. This signalled that the trade war will likely continue longer than markets thought, which dampened growth expectations. The notion that, after a flat first half of 2019, the global economy and corporate profits would return to growth looks increasingly less likely.

This setback was most visible in the government bond markets, where yields, particularly on long term bonds, fell back to either new historical lows or lows last seen a few years ago when the economic environment was far worse. This market- (rather than central bank) driven downward shift in government yields upset risk asset markets. This is because lower growth expectations (which are implied by bond yields) expresses a worse outlook for corporate profits – increasing yields for more risky corporate borrowers (junk bonds of single B and lower), further reducing corporate profit upside potential.

Stock markets around the world suffered their biggest one-day losses since late last year and fell between 3 and 7% between last Thursday and early this week. However, the ‘buy the dip’ mentality quickly came to the rescue – with investors believing that this equity market slump is a buying opportunity rather than the end of the 2019 bull market. On the back of this, equities swiftly switched into recovery mode, with the US markets bouncing back up to the previous week’s highs.

So, all but a storm in a teacup then for investors? Well the increase of political risks to growth in the second half of 2019 is real and, as UK readers know all too well, that is even more true for the UK’s near-term trade prospects with its immediate neighbours. Therefore, unless the seemingly concerted ‘Game-of-Chicken’ on either side of the Atlantic is either called off – or it works out better than ‘car-crash’ scenarios that are currently looming – markets will remain vulnerable. Indeed, as our one of our research providers – Longview Economics – pointed out in their daily market action assessment today, recent rapid market recoveries have initially proven unstable, before a more sustained market recovery has taken hold.

As regular readers will know, we have been anticipating heightened market volatility over the summer, which is why we decided against a risk asset overweight earlier in the year. We remain cautiously optimistic that we will see a further stabilisation of global economic growth over the second half of the year, but we recognise that this expectation is uncomfortably dependent on political developments that are difficult to forecast for the short term. For the medium term, we observe that political tensions and fears before the fact are precisely what leads to these being resolved before they truly become an issue. To this end, we remain optimistic that the Johnson government will not be able to cause a major UK constitutional crisis just to keep a small ‘no-deal Brexit’ interest group in power.

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