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Bond Yields or Equity Prices - Which Predicts the Future Better?

Bond yields suggest stagflation; equity valuations indicate far more positive earnings growth. How should investors interpret this conflicting data?

Cherry Reynard 20 June, 2017 | 12:18PM

There is a deep divide in financial markets: the bond market appears to be telling one economic story, while the equity market is telling quite another. Bond yields across the globe are currently suggesting low levels of economic growth some way into the future. At the same time, the price earnings multiples of equities are making bold predictions about earnings growth. Which is right? 

Both markets have rational reasons for behaving as they are, but they appear to be looking at different metrics. Bond markets are looking at the relative weakness of inflation. Nathan Sweeney, senior investment manager at Architas Multi-Manager, says: “The Federal Reserve predicted that once unemployment reached 4.7%, there would be a pick-up in inflation. That hasn’t happened. It is now at 4.3% and inflation is weaker, well below the Fed’s 2% target.”  

He believes the Federal Reserve is trying to buy time, hoping that inflation will edge closer to its target eventually. However, it hasn’t happened yet and the bond market doesn’t believe it will happen in future. It sees the US economy as on the cusp of Japan-style stagflation. In Japan, unemployment levels have low for some time, but it hasn’t generated any economic growth or inflation.

Bond Markets ‘Very Good’ at Predicting Recessions  

Tom Stevenson, investment director for Fidelity Personal Investing, says that the diminishing gap between shorter-term and longer term rates is also important. This suggests that the bond market doesn’t believe that the economy will withstand rate rises and that rates will have to fall again in future.

He says: “The bond market has traditionally been very good at forecasting recessions. When the yield on short-term bonds falls below that of long-term bonds, it has usually been a precursor to a recession. While the gap is a long way from zero, it shows that the bond market is sceptical about whether growth can continue into the future.”

Stock Markets Supported by Corporate Earnings – And Optimism

The equity market buoyancy has been supported by economic data and hopes over tax cuts in the US. Sweeney says: “The ‘soft’ data is quite good. This measures what people feel and their level of confidence. However, hard data – which looks more at what people are actually doing – is not as good. Soft data is only likely to stay positive for a certain amount of time, particularly if promised policies – such as tax cuts – do not materialise. US companies currently have a tax rate of 38%, which would have reduced to 15%. This created positive sentiment, but this could reverse if they don’t come through.” The bond market has already reacted to the disappointment over tax cuts and spending in the US. The equity market has not. 

Corporate earnings continue to be relatively buoyant, which has also provided support for equity markets. With inflation low, it is easier to generate stronger earnings and this, to some extent, justifies higher valuations. Stevenson also points out that looking at aggregate valuations for the equity market can be deceptive. The rally in the equity markets, particularly in the US, has been narrowly based, focused on a few of the major technology stocks. He adds: “If you strip out those stocks, the markets haven’t done much at all.” 

However, for Stevenson, this selectivity is also a concern: “While it is possible to say that these are companies with great growth prospects, that are growing earnings well, it is true that bull markets tend to end with a focus on a single sector or a few stocks.” 

Which interpretation of the world is correct? Both, and neither. Sweeney points out that there are still plenty of deflationary forces at work – technology development, the rapid expansion of China, high government debt levels, which would support the bond market’s view of the world. Equally, there is historic precedent for stagflation, seen in the Japanese economy. However, he believes it probably excessively gloomy and bond yields are likely to rise (and prices fall) from here. There is also the question of the withdrawal of quantitative easing and how that will impact yields. 

More Positive Outlook Likely to Prevail

Equally, equity markets valuations undoubtedly look high, and there are reasons for concern, but they are still supported by earnings and economic growth. There is also the ‘nowhere else to go’ factor. Investors still receive a reasonable income from the stock market, and income investors have few alternatives. There are also pockets of value. Stevenson for example, says there is still plenty of value in European or emerging markets. 

Sweeney concludes: “Bond markets are over-reacting on the downside, and equity markets are over-reacting on the upside.” Quantitative easing was designed to raise the price of all assets and this is exactly what has happened. However, this cannot go on indefinitely. There are risks in both bonds and equities, but there is more potential upside and income available from the stock markets. For those reasons alone, the stock market’s view may be better supported.  

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Cherry Reynard

Cherry Reynard  is a financial journalist writing for Morningstar.co.uk.