After suffering large falls in May – with the US posting its worst May in nearly a decade – world equity markets seem to have turned a corner in June, already recovering some of their losses. Since the end of May, the FTSE 100 is up by 4%, whilst US markets have risen by more than 3%. This follows from what was an unusually strong first quarter, the best first quarter for US stocks since 1998. Even after accounting for May’s falls, world stock markets are still considerably higher than they were at the end of last year. Since 31st December, the FTSE 100 is up by 9%, the German DAX is up by nearly 15%, the US S&P 500 is up by 16%, and the Chinese CSI 300 is up by over 20%. In most cases, stock markets are within touching distance of the all-time high’s that were set last year. Looking at these headline figures alone, one could be forgiven for thinking that all was well with the world economy.
Yet the bond market is telling a very different story. The 10 year US treasury yield – which moves inversely to treasury prices – has fallen from 2.68% at the end of last year, to 2.08%. Whilst the yield on the 2 year treasury is down from 2.49% to 1.84%, over the same period. Short duration US government bonds are now indicating that the next rate move from the Federal Reserve will be a cut, instead of a raise, which was predicted at the start of the year. In fact, the bond market is now forecasting that the Fed will cut rates twice before the end of this year. This pessimism isn’t just confined to the US, yields have fallen in the UK too. Falling yields suggest that investors do not have faith in the global economy. Investors do not have confidence that corporate earnings will continue to rise, and this uncertainty is shown by their willingness to accept lower government bond returns over a longer period. The difference between the yields on short and long duration treasuries is narrowing, with the curve inverting. Not only is this a signal that investors don’t have confidence in the long term prospects of the economy, it is also historically a very strong indicator of an upcoming recession.
So, essentially bond markets are pessimistic about the economic outlook, whilst equity markets are optimistic. But which one is right?
Bond market cynicism is focused on slowing global growth, negative economic data, and trade tensions. Since April last year, the IMF has lowered its world growth projection for 2019 four times, from 3.9% to 3.3%. The World Bank has lowered its global outlook to just 2.6%, whilst the German, French and Italian central banks have all revised downwards their projections for the year. Japan is the only major economy that is set to grow at a faster rate in 2019, compared to 2018.
Slowing global growth has been primarily blamed on a worsening trade environment, with there seemingly being no end in sight to the US – China trade dispute. May saw the US effectively blacklist the Chinese electronic giant, Huawei, and announce tariff increases on a further $200 billion of Chinese imports. The Chinese responded in kind with their own tariff hikes. A trade war with Mexico was only averted at the last moment, whilst India appear to be the latest target of the President’s trade policies. The deterioration in the trade outlook is most evident in Germany. The third biggest exporter in the world, Germany only narrowly avoided a recession last year, and the growth projection for 2019 has already been trimmed to just 0.6%. The German economy has also been damaged by new vehicle emissions testing procedures, whilst sentiment in Europe has been further affected by a continuation of Italian economic uncertainty and Brexit. With the UK in the midst of a constitutional crisis, and a general election likely before the end of the year, the chances of a no-deal Brexit have increased. Since the end of February, the pound is down nearly 4% against the euro, and 5% against the dollar.
Even the US economy, which is widely acknowledged to be on firmer footing than the rest of the world, is showing signs of deterioration. April’s new job figures were particularly poor, coming in at just 75,000, versus expectations of 185,000. Data in May showed that the manufacturing sector expanded at the slowest pace since 2009. There are also big concerns over the extent to which the Chinese economy is slowing, with first quarter growth the slowest for 3 years.
The weak growth outlook has also been exposed in the oil markets, where tankers were attacked in the Gulf of Oman. Up to 40% of the world’s seaborne crude oil passes through the Strait of Hormuz, making it an integral part of the global economy. Oil prices rose on the day of the attacks, up more than 4% at one point. However, prices quickly fell, with the market appearing to shrug off its importance. This episode shows just how powerful the global demand fears really are.
Stock market optimism, on the other hand, is based upon solid US economic growth, low inflation, and a move towards loosening monetary policy. The increased likelihood of interest rate cuts naturally makes equities more attractive, with a rate cut effectively increasing the value of future company cash flows. Combined with low inflation and fairly strong growth, this is would be a perfect outlook for stocks, where it not for all of the external noise. So, the stock market is essentially downplaying fears surrounding global trade. The market believes that the trade disputes are only temporary and will be resolved soon enough. Additionally, Chinese tax cuts and infrastructure investment provide hope that a Chinese slowdown can be minimised and contained. Years of extraordinary monetary stimulus have also affected the market, with participants now accustomed to buying any dips, with comfort that the Fed will do whatever it takes to stabilise markets (the Powell put). The equity market also believes that the Fed should and will cut rates, and that this is positive for stocks going forwards.
In reality, it’s most likely that neither equity markets or bond markets are telling the whole story. A middle ground outlook is more probable, with equities overly optimistic and bonds overly pessimistic.
There are some other factors that are perhaps influencing bond yields and distorting the signals that are coming out of the bond market. US government bonds are safe havens for global capital in times of economic uncertainty. Outside of the US, the yields offered by the bonds of developed markets are generally much lower, with the German 10 year yield negative. This makes US treasuries much more attractive, and attracts haven-seeking capital, pushing yields down.
Equity investors, meanwhile, seem to be ignoring the fact that we are ten years into an economic expansion and bull market. Slowing global growth, low unemployment, a deterioration in sentiment, and an inverting yield curve, all point to this being the latter stage of the economic cycle. Bond markets are signalling that there is a 1 in 3 chance of a US recession within the next year. More and more investment banks are starting to predict recessions for next year and in some cases, even the second half of this year. Add an upcoming US election into the mix, and it makes the policy outlook even more uncertain. There are clearly downside risks to equities and investors should be mindful that the latter stages of the cycle are typically characterised by lower equity returns.
But bull markets and economic expansions don’t die of old age. Far more likely is central bank policy mismanagement. If history has taught us anything, it’s that knowing when to change interest rates is a virtually impossible task. This week’s US Federal Reserve meeting, and the reaction of the markets, should make things a bit clearer.
GCIS - Commercial Intelligence - Content/ Market Intelligence
This does not constitute investment advice. The value of investments can go down as well as up. Past performance is not an indicator of future performance.