I'm for ever blowing bubbles

A 11% year to date rise in  the FTSE 100 may make it one of  the best performing of the leading developed equity markets this year, but it still does not come close to the performance of UK gilts up 34% year to date. The rise in gilts is partly courtesy of Mr Carney and his band of merry men. 34% return in 7 months from a risk free asset, would not make sense to an investor dropped onto earth from another planet.

Bonds and equity prices are linked, lower bond yields allow for higher equity multiples, for this reason, aside from the comparison to bonds, equities look expensive on most multiples against history. The corollary of that is if bond yields start to fall so will equity valuations. This is probably part of the rational why cash holdings are high relative to history, and the price of gold remains robust.

Bonds are probably in a bubble driven partly by the actions of central banks. Yields have fallen to levels no “expert” would have forecast. Fear of equities remains as  $80bn dollars have been pulled from US equity mutual funds, and only $23bn has been put into equity Exchange Traded Funds, on the other hand bonds continues to see net inflows.

Currently one gets the sense that complacency has entered into the bond market, investors feel safe in a “safe asset”. Inflation is low, growth is modest and governments continue to buy bonds.

What could rattle this cage and change this complacency? The best outcome for equity investors is that bond prices fall as a result of stronger economic growth. This would allow company profits to grow, valuations would not fall dramatically as the increase in profits would naturally reduce valuations, historically the circle of life.

Other scenarios that could make bond prices fall that would not be so attractive for equity markets is a default by a lender. For example, the unexpected Russian default in the late 1990’s. Fears last year that the oil price fall would lead to defaults, that would then contaminate other sectors. As the tide rushes out it takes all with it, could well be the effect.

The other scenario that may not play out so well for equity investors is a term known as stagflation, something the UK suffered from in the early 1970’s. This is inflation which is not accompanied by economic growth but as a result of rising prices.

This is what the Bank of England were hinting to when they suggested, ahead of the Brexit vote, a sharp fall in sterling could lead to a raising of interest rates. If the cost of goods rises due to higher import prices, employees need to be paid more. Greater supply of money increases prices further, but without greater production there is no economic growth In this scenario bonds become less attractive as the value of capital is quickly eroded by inflation.

The bond bubble has to bust at some stage, the reason you takes your money and pays your choice. Just don’t think of bonds as being risk free. 

Posted on August 16, 2016 .