Judging by the behaviour of the equity markets and the bond markets of late, one would be forgiven for wondering whether the global economy is on the cusp of the biblical seven years of plenty or hurdling inexorably towards seven years of famine.
In normal times, equities and government bonds move in opposite directions. When investors feel confident about the future, they are willing to take on more risk and therefore buy equities, which offer a better return if the economy improves. At the same time, they sell lower risk but lower yielding assets like government bonds, thereby pushing down their prices and driving up their yields.
When investors get nervous about the economic outlook, they usually sell equities and buy government bonds, driven by the confidence that governments will pay back their debts. Government bonds are considered to be a safe bet even though their return is low. Increasing demand of bonds pushes their prices higher, causing their yields to drop. So falling yields are to the economy what atmospheric pressure is to weather forecasting: when yields drop, it is often a sign that investors are seeking a safe haven from a brewing storm.
Equity prices across the globe have rallied sharply so far this year, albeit after a global sell-off towards the end of last year. The US S&P 500 share index, for instance, is currently close to an all-time high, with a gain of no less than 19 per cent year to July. It is a similar story for equity markets across the globe as well as for high-yield (risky) debt and emerging-market currencies, as investors seem to be confident about the future and taking on more risk.
When investors get nervous about the economic outlook, they usually sell equities and buy government bonds
Given the rosy scenario being portrayed by the equity markets, one would expect investors to be selling lower-yielding, risk-free government bonds, thereby committing their money in the potentially higher yielding equity markets.
However, yields on government bonds have been falling fast in the past months, at the same time and everywhere too: in Japan, Britain, Australia, Germany and the US. Long-term yields on government bonds around the world are hitting some of their lowest levels in recent years, warning that turbulence may be afoot.
So, is the stock market right or should we heed the red alert of the bond market?
Admittedly, the bond market has a better track record on calling turning points in the economy, and it would be unwise to ignore it. It is the adult in the room, so to speak. However, only time will tell whether a feast or a famine lies ahead.
George Mizzi is a business graduate, an associate of the Chartered Institute of Bankers and CeFA qualified. He currently works as a fund and technical analyst at Bank of Valletta Wealth Management.
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