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Can the joint rally in shares and bonds continue?

Anthony Quirk

Saturday 21st June 2003

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In May, most major equity markets continued their rallies from April. After lagging last month Japan rebounded with an 8% rise in the Nikkei 225. Our local sharemarket also had a strong performance, being up 4% (NZX 50). As was the case for shares, bonds continued their strong April performance with gains in May of 2.4% for domestic bonds (CSFB Index) and 2.0% for global bonds (Lehman Global Aggregate Hedged Index).

So May was another month where both the bond and equity markets rallied together – can this continue or is the party going to stop in one or both markets?

Many investors think that bond and share returns usually move in completely opposite directions. For example if a country’s economy is weak this can hurt company profitability and therefore the sharemarket, while at the same time causing interest rates to fall from lower inflationary pressures. Such a fall in interest rates results in capital gains in bonds, at a time when capital losses on shares might be occurring.

However, looking at the actual data of bonds versus equity returns may surprise some. Rather than an inverse relationship (or a correlation of close to –1.0) bonds and equities had no relationship (a correlation of close to zero) over the past 20 years.

In New Zealand the correlation between domestic bonds and equities is +0.1, based on data over the past 22 years. If a shorter time frame of seven years is used this figure remains the same.

Investing from New Zealand in hedged global bonds and unhedged global equities produces a correlation of +0.2 over the past 18 years. If hedged global equities are used, over the past 15 years, then this becomes 0.0.

While such data can be period specific the lack of negative correlations between bonds and equities is confirmed by some Credit Suisse First Boston data. Their research showed that there has been a positive correlation between US share and bond returns “for around 125 out of the past 150 years”.

So how can bonds and equities rally together? The 1990s were a classic example of a virtuous cycle of lower interest rates (from falling inflation) helping to fuel an equity rally. Falling interest rates meant a lower discount rate could be used to value future cashflows of companies, which in turn meant their valuations rose. Moreover, company interest servicing costs fell, thus helping profitability levels.

Therefore you can get capital gains from both bond markets (from falling yields) and equity markets at the same time. In part, this may be what the markets have exhibited over the past few months. The difference this time is that we are not in a period where inflation is falling rapidly and the CSFB research showed “that periods of negative correlation between equity and bond returns have coincided with periods of stable inflation”.

So, another interpretation is that the expectations of the participants in the equity and bond markets are different, with bond managers more bearish about the economic outlook than equity managers. If this is the case, then at some stage one market will be right, and the other wrong and the joint rally in bonds and equities will come to an end.

Let’s consider what could happen from here.

Scenario One: Both shares and bonds continue to rally strongly. This seems an unlikely scenario simply because bonds are at 50 year lows in the US and for them to rally further more evidence of deflation is probably required. If this does eventuate it is hard to see how equity markets would rally as well.

Scenario Two: Shares rally and bonds stabilise or sell-off. For this to occur the global economy needs to grow more quickly, and this needs to feed through to better company profitability. However, this linkage does not always happen. If it does not over 2003/04, then the US sharemarket may be vulnerable as it is still trading at moderately high P/E levels and has an expectation of solid corporate profit growth built into current values. In other words we could still see global economic growth rise (hurting bonds) but without sharemarkets lifting.

Scenario Three: Shares sell off and bonds stabilise or rally further. This is the deflation scenario, which is great for bonds (see Japan’s experience where 10 year bonds are currently about 0.5%) and terrible for equities.

Scenario Four: Shares and bonds sell off. This would require stagflation (high inflation and low growth) to raise its ugly head. This is possible, as the US Federal Reserve is trying to reflate the economy and may find that inflation rises but not economic growth.

Scenario Five: Shares and bonds stabilise at current levels and range trade from here. After a significant rally in both markets some consolidation is likely in the short-term. However, in the longer term some market volatility and divergence in bond and equity returns is more likely.

Of the various options, my view is that scenario five followed by two is the most likely result, as the significant fiscal and monetary stimulus in the US takes hold. However, the outcome is not certain and the differences in future bond and equity returns over the next few years are potentially substantial depending on which scenario does occur.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Reveiw here

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