Equity managers often regard the bond market as a kind of all-seeing oracle. Changes in government bond yields can give insight into future expectations of economic growth, while the relationship between index linked and government yields can show where inflation expectations are. Additionally, the level of credit spreads gives an idea of the health of various industry sectors. Equity investors generally believe that bond markets, at least in the case of government bond markets, give a timelier and more accurate signal than market forecasts or equity market levels.
One reason why investors believe this in the case of government bonds is that investors in this highly liquid asset class are likely to be more dispassionate as there are less variables to argue about. Another is that liquidity is such that the asset class is hard to manipulate, although this is perhaps less so in the era of direct central bank intervention. At the same time, aggressive regulation of some of the main buyers of government bonds, insurance companies and pension funds has also likely made the price signal less accurate.
In the case of corporate bond yields, the case for a more accurate assessment of future prospects rests on the different risk reward profiles of investors. Equity investors face the prospect of a total loss but with the potential for practically unlimited upside. Bond investors have only the coupons and repayment of capital to look forward to, but also face unlimited downside. This imbalance makes equity investors prone to look upwards while bond investors are more likely to consider downside risks as they have no prospect for long term gains beyond the fixed upside.
Even in the case of corporate bonds, these signals are probably less clear than in the past. Central banks have been active buyers of corporate bonds for some time with the specific intention of driving down yields. The absolute signal from credit spreads may now be less of an indicator of the downside risks facing the economy, although the difference between industries possibly still does.
What do these bond market signals imply for the world’s economy at the moment? Government bond markets imply extremely poor long-term outlook for global growth for many years to come, possibly as a consequence of the massive debt burdens on most developed economies. The same goes for inflation: there is little prospect of inflation picking up materially for a long time, at least if you believe the bond market signals.
Credit spreads remain considerably higher than the levels at the end of 2019, implying that the downside risks in many industries remain elevated. Those industries most impacted by the economic slowdown and lockdowns still have elevated credit risk, although much less so than during the height of the crisis while some more defensive areas are already back at previous levels.
In many ways the story from bond markets supports the story within equity markets, some sectors remain depressed while others have powered ahead. In a world where growth is likely to remain scarce, those industries which are benefitting from the changes become more highly valued. However, industries that are suffering remain out of favour.
We still favour structural growth industries such as the digital economy, renewable energy and robotics. Whereas in corporate bonds we favour shorter duration and better quality credit. The key indicator we would expect to see before making any changes to our basic allocation is a more sustained rise in government bond yields. This would imply that growth expectations have begun to shift, making the outlook for the harder hit parts of the market more favourable. Following this, we would expect to see the more value and cyclical areas to begin to outperform more defensive and growth sectors. Only once we see strong evidence of this change will be inclined to make a substantial shift into value or deep cyclicals.
David Jane, Premier Miton Macro Thematic Multi-Asset Team, 14.10.2020.
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