New article from Tatton Investment Management: Bond rally musings

3 June 2019

It all seemed to make a lot of sense to the media commentators this past week: government bonds rallied and equity markets fell because investors no longer expect a return of meaningful global economic growth during 2019, and in the UK the probability of a hard Brexit has supposedly surged because The Brexit Party won the most votes in the UK’s European elections. Taking a step back, both conclusions seem a little premature.

On the bond market side, yields have indeed fallen, which tends to indicate falling growth expectations and thus lower levels of expected inflation, for which investors expect yields to compensate. Recently however, inflation expectation changes have been closely correlated with oil price changes, which are not only driven by demand due to economic activity, but also by supply-side changes and by the ebb and flow of speculative demand positions. After the gradual rise in the oil price during the first four months of the year it has currently fallen back as Middle East tensions ease and the US shale oil producers increase their output. This price decline easily explains the recent fall in inflation expectations and thus the fall in longer term bond yields – if one is so inclined. 

Last year, equity markets staged a marked correction triggered by fears that rising bond yields might cause a wave of corporate defaults that would put an end to the extended prevailing economic cycle (which did not happen). This year the fear is that Trump’s trade wars will do the same through slumping global trade volumes. It is remarkable then that equity markets are still sitting on healthy 2019 gains, despite the declines over the course of May.

It has been argued that markets are misjudging the situation and that the trade war will carry on and will drive the global economy into recession. Admittedly there are indications that both sides - US and Chinese - are digging their heels in and preparing for a drawn-out economic conflict. On the other hand there are various other indicators that tell us they remain open to a negotiated solution, which would also be strongly supported by rational assumptions, for instance that Trump can only continue dreaming of a 2020 re-election if he does not drive the US economy into the ground in the meantime.

The better explanation for the (still) relatively sanguine equity markets is the various economic factors that have turned from headwinds to tailwinds over the past year. Lower yields and lower energy prices are a boon for the economy as they lower input costs for industry and increase the headroom for discretionary expenditure by households.

For the time being there appears to be a fragile balance between the two ever-present forces in capital markets – fear and greed. If Trump and Xi manage to agree new and improved trade terms before the end of the summer, then the current market conditions might be described as a loaded spring. If they indicate that economic hardship – at least temporarily – is the more promising route to long term prosperity (at least in their minds), then the markets are likely to riot – and potentially thereby force them into a rethink.
Given capital markets always look ahead and try to anticipate through valuation adjustments what is likely to happen before it actually does, it is entirely possible that they will become increasingly more volatile, as politicians engage in what feels like a gigantic game of “chicken”. Broader economic sentiment may sour during this period, however – for the time being – lower global trade volumes are being counterbalanced by higher employment and higher service sector growth.

Returning to the second point at the beginning of the article, it would appear that an overwhelming majority of the participating UK electorate voted for parties that are aiming for no Brexit, a soft Brexit or another referendum. It is therefore hard to see how a new leader of the Conservative Party would be able to achieve anything closer to a compromise Brexit than the outgoing Prime Minister has been able to. General elections are regularly mentioned, but after last week’s results it is hard to see how MPs could be enticed towards making that happen.

It would therefore seem that the Brexit date will be slipping further, and beyond October, unless the new Prime Minister indeed has the courage to choose the ‘emergency exit’ of another referendum to solve the enduring impasse. Then all options are open again, although if last week’s election results are anything to go by, a hard Brexit would struggle to find a majority, now that the consequences of such a step have become somewhat clearer to more parts of the population.

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