Rising stock markets should, as the theory goes, be accompanied by falling “safer” bond prices as investor risk appetite rises. However, the opposite scenario is currently underway. In spite of rising stock markets, bond prices have continued their ascent on the back of sustained “investor” demand.
As a result in the UK, the benchmark 10-year government borrowing cost remains close to its six month low, and yet the FTSE 100 is at a post financial crisis high. Similar trends can be seen in the US and Germany where, in the case of the latter, the government 10-year borrowing cost is at 1.24%, not far from a record low.
The question is therefore whether one market is significantly misplaced in its expectations for the economic outlook or simply that other factors are at work. What have been the drivers to the pricing of sovereign debt?
Stimulus
The continuing efforts of central bankers to stimulate growth and the lack of confidence among corporates and households to spend, has resulted in substantial, or excess liquidity, within the financial system, in search of a home.
This combined with the on-going scale of direct purchases of assets by central banks through Quantitative Easing has diminished the supply of these “prime” assets in which to invest. At the same time as demand for such assets has grown assisted by the various Basel accords that have required banks to replenish their asset base.
Another key factor is the inflationary outlook, which as a consequence of weakening commodity prices appears increasingly benign. This is especially apparent in the eurozone which saw inflation at 1.2% in April. Again this can arguably be seen as supportive of both bonds and equities.
On the latter falling commodity prices act as a boost for consumers and businesses, barring of course the producers and it also means that central banks have greater scope to increase stimulus. On the face of it, and given recent economic data, the global economy remains in comparatively poor health with numerous and substantial challenges still to overcome.
Why stocks?
Such an environment is supportive of bonds but, it is not perhaps immediately obvious why stock markets would be in such a forgiving mood. The first point to bear in mind is that economic growth and corporate earnings are not closely related and it is often the case that low growth is accompanied by reasonable corporate profitability.
Recent corporate results have been mixed, with the US generally faring better than Europe. In both cases the rate of sales growth has disappointed but profits have typically reassured. There has also been quite a marked difference in the fortunes of the defensive companies relative to more cyclical sectors, and certainly the latter group has seen numerous profit warnings recently, with the former generally leading markets higher.
Reversal
Nevertheless, the obvious problem with the above is that having risen in unison there is no reason why a move in the opposite direction cannot also occur. At this time, while bonds are looking overvalued, one suspects the inflationary outlook combined with central banker efforts should remain supportive of bonds and wider asset prices.
Although in the longer term interest rates will inevitably rise and so bond prices must fall. The severity of the financial crises and the challenges of its aftermath mean that this is far from an ordinary time in economic history and a “normal” environment may still be some way away.
