Could the Equity and Bond Markets Both be Right About the Macro Outlook?
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Yes. While equity and bond markets don’t often rise in tandem like they have lately, history suggests that both recent moves could be warranted if central bank stimulus successfully extends the cycle. But that is a big “if”; several moving parts cloud the macro outlook, and markets are assuming that central banks can reverse the recent economic slowdown.
The slowdown in the global manufacturing sector and deterioration in US-China trade negotiations dominated the market narrative in first half 2019. Safe-haven assets benefited from increased macroeconomic uncertainty—US Treasuries rose 5.2% in first half 2019. Yet, even as US Treasury yields plummeted, US equities surged, rising 18.4% over the same period and reaching record highs in late June. Conventional wisdom suggests that when inflation is contained (as it is today), equity and bond prices typically move in opposite directions. So what gives?
A key reason for the apparent disconnect between equity and bond movements is the market’s anticipation of monetary policy easing by global central banks. While major central banks have yet to actually ease policy, last month both the Federal Reserve and European Central Bank (ECB) signaled a willingness to provide fresh stimulus to sustain the expansion if necessary. More accommodative monetary policy should boost bonds. And why are equities rallying amid the economic softness and trade uncertainty that are commanding the attention of central bankers? Easy monetary policy can also support equities, as long as central banks successfully head off a more protracted economic downturn and extend the expansion.
We can categorize the last six Fed rate-cutting cycles into two distinct groups: recessionary cuts (1989, 2001, and 2007) and “insurance” cuts (1984, 1995, and 1998). The latter periods included modest easing followed by an economic soft patch, while the former saw more substantial easing and preceded a more severe downturn. Unsurprisingly, safe-haven bonds performed well following both types of rate cuts, but the same cannot be said for equities. US equities averaged an annualized return of 24.6% over the 24-month period following the first rate cut during insurance cuts, versus -8.1% during recessionary cuts.
Both equity and bond markets appear to have fully priced in an insurance-cut scenario, and some evidence suggests this could be the most likely outcome. Typically, at the beginning of Fed easing cycles that precede a recession, several economic- and market-based indicators are flashing red prior to the first rate cut. Today, few such signals warn of an imminent recession; some segments of the yield curve have inverted, but credit spreads and labor markets aren’t signaling a severe near-term downturn.
However, several factors threaten this view. Currently, the global growth slowdown has mostly been contained to the manufacturing sector, but if this sector slows further, it could eventually crimp the broader economy. Trade tensions are a key source of this weakness in manufacturing, and further dust-ups between the United States and China would increase the probability of a spillover to the broader economy. In this scenario, even significant easing may be insufficient to prevent a protracted slowdown.
Furthermore, compared to prior cycles, central banks today have fewer tools at their disposal to counteract an economic slowdown. This is especially true in Europe and Japan, where policy rates are already negative. The ECB’s and Bank of Japan’s limited firepower could reduce their ability to prevent a modest slowdown from turning into an outright recession.
Equities and bonds both benefited during first half 2019, as central banks signaled their willingness to be more dovish. Levels of several economic- and market-based indicators suggest that both markets could sustain their rallies, if central banks follow through with accommodative monetary policy, and if that dovish policy extends the expansion. However, the uncertainties around the macro outlook, combined with the limited firepower of global central banks today, boost the risks to this outlook. With an insurance-cut scenario looking fully priced in to both equity and bond markets, any indications that such a near-term cut is less likely could spur drawdowns in both equities and bonds.
TJ Scavone, Investment Director on Cambridge Associates’ Global Investment Research Team