Tatton News Archive

New article from Tatton Investment Management: Market spat between bond and equity markets

19 August 2019, 12:00am

Last week, we suggested that the recent market pullback (down, then up to almost recovered) is unlikely to be the end of this bout of market volatility. Sure enough, markets became even more volatile over this week, despite the Trump administrationâ€™s delay to the next round of tariff hikes against China â€“ a move some saw as a desperate attempt to stop the rapid souring of US investor and economic sentiment.

Trumpâ€™s proverbial blinking first in his own stand-off only provided a short 24h reprieve to stock markets before they succumbed to the next scare (although that scare was neither new nor unexpected). This week it was the inversion â€“ at least temporarily â€“ of a crucial part of the US and UK government yield curves that spooked markets. Essentially, demand is increasing for safe-haven long maturity bonds by institutional investors that are unnerved by the vagaries that trade politics add to the already weak economic outlook. Because of the inverse relationship between bond prices and their yield, the higher demand has led to yields on 10 year bonds being quoted lower than the yield for bonds with just 2 years to maturity (more on this in the second article this week).

Given this yield level inversion has in the past almost always eventually been followed by an economic and stock market downturn, investors swiftly â€˜forgotâ€™ that Trump had just signalled a higher probability of a trade settlement and rushed for the exit even more vehemently than the week before. At the time of writing on Friday, markets had stabilised once again as â€˜buying the dipâ€™ mentality supported stock markets, albeit only to lower levels.

The ensuing market and academic debate has been insightful. Even previously bearish commentators noted that bond markets appeared to predict a recession which, to come to fruition, would require a lot of the prevalent political risks ending in the worst case scenarios all at once â€“ which is somewhat implausible given historic precedent.

It is always dangerous to suggest that â€˜this time is differentâ€™, but we have to note that 10 years of extraordinary monetary stimulus have likely distorted bond market dynamics to a point that have also undermined the predictive powers of yield curve inversions. As encouraging as the market stabilisation is, the current nervousness of stock markets and previous episodes of similar pullbacks of May 2019 and October 2018 suggest that we may still not have seen the end of this bout of late summer volatility.

In other news, last weekâ€™s political EU hot spot of the Italian government crisis calmed, as immediate general elections and a sure win for the Lega Nordâ€™s populists appeared to drift into greater distance, thereby reminding more of what tends to be associated with political â€˜normalityâ€™ in Italy than heightened risk.

In the UK, there was a feeble recovery of Â£-Sterling versus the â‚¬-Euro and the US$, after a lowering of noâ€‘deal, Hard Brexit expectations and encouragingly strong annual real wage increase figures of 1.8% (I.e. after subtracting inflation). All of this suggests the UK economy is not doing too badly. The fly in the ointment is that the strong employment data corresponds with exceptionally weak business investment figures, which could lead to higher inflation. This would make it more difficult for the Bank of England to follow the US Federal Reserveâ€™s example of lowering interest rates to stimulate the economy should it become necessary.

The remainder of the newsflow tells us that the global economy is not yet re-accelerating, but also not sliding towards outright recession. In such an environment, a mild market correction â€“ like the one we have just witnessed â€“ can offer better entry prices for those who have been waiting to invest. The political risk scenario and nervous markets, however, also mean that now is not the time to be taking on more market risk than one would normally be comfortable with. For this to happen, we would need to see a few more substantially positive surprises from the political side; Donald Trumpâ€™s tariff retreat last week is not quite enough.