Cheaper bonds mean cheaper stocks

For answers about the global stock market dip of the past couple of weeks, we think you need to look at the bond market. That, mixed with some jumpy robots, is most likely the cause, we believe.

There’ve been a lot of trade threats – and action on them – over the past month. And then a massive storm ripped across the southern US. Hurricane Michael made landfall roughly at the same time American markets took a tumble. To top it off, China’s numbers have been getting steadily worse over past months. This leads some concerned investors to believe that global demand is about to fall significantly. If that were the case, markets would be in for a much greater fall than we have seen so far.

But, from what we see, it appears most likely that the sudden, sharp drops in global markets were triggered by a rise in US yields. On 3 October, US Federal Reserve Chair Jay Powell said interest rates, which were raised to 2.25% last month, were “a long way from neutral”. If US economic growth continued to be very strong, more interest rate hikes were likely. Almost immediately, US Treasury yields took flight; by 9 October the 10-year yield was 19 basis points higher at 3.25%. Short-term bond yields moved upwards too, but by a smaller amount.

Suddenly, the cost of capital – how much return shareholders and creditors demand for risking their cash – was significantly higher. The effect on stock markets was modest at first, but then accelerated last week as markets caught up: today’s value of all the cash you expect businesses to make in the future is much less if your cost of capital is higher. And if you factor in the worries about Chinese growth, general nervousness about trade and a tick down in US PMIs (surveys of businesses that tend to lead harder economic figures), perhaps there won’t be as much of those future earnings either. That would push values lower again. So you have a correction in markets, with the S&P 500 down 7%, the FTSE 100 down 7%, and the Shanghai CSI 300 down 9%.

Technology and companies that have done very well over the past couple of years were hit hardest. In a way, they’re victims of their own success. They tend to be on higher multiples of earnings and therefore their prices are more vulnerable to a rise in the cost of capital. Even though, from a business standpoint they actually have the low debt levels, stable earnings and high margins that allow them to take higher costs in their stride. Put another way, many of the companies that were hit hardest in the last couple of days are exactly the kind of companies that should do best if a slowdown does actually eventuate. At least, in our view.

Index

1 month

3 months

6 months

1 year

FTSE All-Share

0.7%

-0.8%

8.3%

5.9%

FTSE 100

1.2%

-0.7%

8.9%

6.1%

FTSE 250

-1.6%

-1.8%

6.1%

4.9%

FTSE SmallCap

0.0%

-0.1%

6.0%

5.1%

S&P 500

0.2%

8.9%

19.5%

20.6%

Euro Stoxx

-0.7%

1.4%

5.4%

1.4%

Topix

2.7%

4.5%

7.7%

13.0%

Shanghai SE

2.4%

-3.4%

-12.4%

-16.3%

FTSE Emerging

-0.9%

0.6%

-1.8%

2.0%

Source: FE Analytics, data sterling total return to 30 September

 

Quality vs cheap

We know this is pretty cold comfort, as the early weeks of October have been painful for many, ourselves included. ‘Value’ companies, typically those with higher leverage and whose fortunes are more anchored to those of the economy, have done better than growth in the recent downdraft. The S&P 500 Value Index is down about 5%; the S&P 500 Growth Index is down 8%. But zoom out a bit: year to date, growth companies are up almost 7%; value is down 3%. In the coming months economic growth may slow, companies may lower earnings guidance; but the economy could be perfectly fine and shrug off the rise in yields. Either way, we think quality companies – those with low debt and strong cash flows that are less reliant on greater economic growth – are the best bet for the future.

We warned that this year would be volatile and we were right. Broadly speaking, we expected positive returns from equities, but unless you held a narrow part of the US market we’ve been wrong so far. Earnings have risen considerably this year, but price/earnings ratios have dipped. In some respects it’s quite healthy, given the significant upward move in all markets over the past decade. In others, it’s a little worrying that investors are so sceptical of future earnings. You can see that in the punishment stocks take for any misstep, regardless how minor, even as the US economy looks and feels like it’s going well.

A few bad numbers and an offhand comment by the Fed can be enough to send investors stumbling for the exits, worried sick. Yet, just as quickly, a return to resilient data and a few healthy company earnings reports can send markets on a similarly dramatic upward swing. There are risks out there, but they don’t seem immediately pressing. Markets hardly blinked when North Korea threatened nuclear war a year ago; this month they panicked over higher discount rates.

What made this sell-off so jarring could be that bonds and equities posted simultaneous falls. Portfolio management 101 says that when equities fall, safe haven bonds tend to gain in price. That negative correlation broke down in the past couple of weeks – as we said at the beginning that’s because the fall in bond prices sparked the fall in equities. But it’s unnerving.

We think bonds will continue to be a good balance to portfolios in the long term, but short term we could be in for more bouts of simultaneous falls if the pace of US monetary tightening carries on unchanged and economic growth starts to tail off.

 

Bond yields

Sovereign 10-year

Sep 30

Aug 31

UK

1.57%

1.43%

US

3.06%

2.86%

Germany

0.47%

0.33%

Italy

3.14%

3.23%

Japan

0.13%

0.11%

Source: Bloomberg