Is everything too quiet on the Western front?

Image of sunset in desert

Well here’s a funny thing. On one hand, global stock markets are casting aside the gloom that characterised late 2018 and are off to the races once more. All eight of the major geographic options available to advisers and clients have generated positive total returns in sterling terms so far in 2019 (compared to just two – Eastern Europe and the US) across the whole of last year.

Global stock markets are booming in 2019 …

Source: Refinitiv data

But on the other, global Government bond yields are in retreat. The graphic below shows that the yield on 10-year German and Japanese Government paper is back in negative territory. Meanwhile the UK 10-year Gilt yield is back at the 1% mark for the first time since summer 2017 and the US 10-year Treasury yield is hovering around 2.5%, a level last seen just before Christmas 2017.

… but global bond yields are in retreat

Source: Refinitiv data

Granted, the total returns on Government bonds are nowhere near as racy as those served up by equities, with a global index of investment-grade sovereign debt having gained 1.2% in the first three months of 2019 in sterling terms (with a gain in the pound having weighed slightly on the outcome).

But this still looks odd, with stocks advancing so smartly yet bond yields retreating so quickly at the same time. This seems inherently contradictory, with stocks seemingly pricing in a robust economic environment and healthy earnings growth and bonds taking a gloomier outlook, factoring in a pause in central bank activity as the monetary authorities respond to the weak economic data that predominated in late 2018 and early 2019.

Mixed messages

But the deeper you dig, the better the news seems to get from January to March 2019. According to data from Bloomberg, America’s S&P 500 stock index generated its best quarterly gains since Q3 2009. In addition, oil made its fastest three-month advance since 2002.

And it was not just Government bonds that did well. US investment-grade corporate bonds have just offered their best total returns in a calendar quarter since 1995 and sub-investment grade company paper (or high yield or junk debt) had its best three-month period since 2002.

On top of all of that, there seems to be very little fear about, even if the performance of haven assets such as Government bonds would suggest otherwise.

This can be checked by looking at the Chicago Board of Options Exchange’s (CBOE)’s volatility indices, which measure expected market volatility in the next 30 days across a range of asset classes.

In the USA, the VIX index, which tracks expected stock market volatility, stands at 13.7 against a lifetime average of 19.2. The MOVE, which gauges expected volatility for the US 10-year Treasury bond, reads 4.4 against a long-term average of 6.3.

Expected volatility readings are low across the board …

Source: CBOE, FRED - St. Louis Federal Reserve database, Refinitiv data

In the UK, the VFTSE, the British version of the VIX ‘fear’ index, reads 12.8 against its long-term average of 19.2. The only area where traders seem to expect any wild activity is sterling, where the current level of 14.7 easily exceeds the BPVIX index’s lifetime average of 10.1.

… on both sides of the Atlantic, with the exception of sterling

Source: CBOE, Refinitiv data

Monetary medicine

Given the prevailing lack of clarity on the vexed issue of Brexit at the time of writing the state-of-alert with regard to sterling is easy to understand.

Yet it may also be possible to square the circle between rising stock prices and rising bond prices, too. Bonds may be rallying because economic weakness could mean interest rate cuts and more Quantitative Easing – the Federal Reserve and European Central Bank quickly parked any plans to tighten policy this year and they have been swiftly followed by central banks in Australia, New Zealand, the UK, Indonesia and Taiwan to name but five.

QE would mean more price-insensitive buyers of bonds so canny fixed-income traders are getting in now. And if they drive bond yields lower that takes us back to the TINA argument for equities (There Is No Alternative), especially from a yield perspective. That may explain why stock markets are motoring.

This all looks very bullish and could set the scene for a melt-up, with the compliments of the world’s central banks. But experienced advisers and clients will also remember how long periods of below-average volatility in 1993, 1996, 2005-06 and (to a much lesser degree) 2017 and 2018 preceded sudden market dislocations of varying length and depth. As legendary investor Warren Buffett regularly counsels, “Speculation is most dangerous when it looks easiest,” so advisers and clients might like to use this year’s first-quarter bonanza to reassess any tactical portfolio allocations, or at least stress test them, to ensure that risk is properly calibrated according to well-defined long-term goals and target returns.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.