After so many questions about why equity markets are finally showing some signs of weakness, I thought I’d build upon what I wrote in today’s Index Focus.

One reason for general equity market weakness is a continued 2018 rise in bond yields (especially the US) to hit multi-year highs, offering better relative returns versus what many had already regarded as overvalued stocks.

This bond reversal comes as prices (which move conversely to yields) turn down from multi-decade, central bank stimulus-fuelled highs, and yields turn up from their lows. This derives from investors pricing in higher expectations of an accelerating US economy, producing higher inflation and requiring higher US interest rates, as Trump tax reform boosts a pre-existing recovery.

The US is already planning on issuing more debt to fund a rising deficit under tax-cutting big-spending President Trump. This may require higher coupons/yields to remain attractive, thus compounding the bonds vs equities argument. Might Trump’s spending (and thus borrowing) do some of the Fed’s monetary tightening work for it?

Another culprit is a USD under pressure, even after today’s US Jobs report included strong wage growth data that could stoke inflation and push the Fed to hike interest rates more quickly. The problem is the weak USD means persistent GBP and EUR strength, which is a boon for US companies, but a hindrance for those in Europe. The UK UK Index and German DAX are both heavily exposed to international earnings, which are now worth less in their home currencies. Remember the benefit from a weak GBP post-referendum? Well it continues to evaporate as GBP moves north.

And there are several reasons for a weak USD. The Fed has already hiked several times and is unwinding its quantitative easing (QE) bond-buying stimulus programme. A forced buyer for US treasuries has thus left the market, replaced by a gradual seller. The relative potency of Fed policy tightening is also no longer what it was, with most of the hard work having already been done. Furthermore, as global growth improves, peer central banks will catch up (hawkish tones already been heard) in terms of policy normalisation, potentially offering better returns, increasing demand for their own currencies.

A weaker USD is good for commodity prices, giving non-US buyers more bang for their buck-equivalent. However, a high oil price thanks to OPEC-coordinated production cuts also means that big oil exporting nations are selling even more dollars, keeping downward pressure on the US currency, applying upward pressure on peers.

Lastly, we have some rotation out of what many viewed as overvalued US stocks which benefited handsomely from an already weakening USD and strong Trump tax-cut inspired Santa Rally. One which flowed seamlessly out of Dec and into Jan, only for Q4 results season to deliver some disappointments this week. The latter has dealt a blow to sentiment, begging questions about the US economy and whether it can deal with more rate hikes, leading to sales of shares which may be exacerbating those aforementioned FX trend hindrances, especially if UK/Eurozone investors are repatriating funds.

That said, the stateside sell-off pales in comparison to that in Europe, with the UK’s UK Index offside by 3% YTD and Germany just below the waterline. All the while US indices hold onto 5-7% gains, buoyed by a weak USD (flatters US corporates) and macro data suggests a solid economic recovery which can indeed support higher interest rates.

There is much debate about which is the dog and which is the tail, and which has a bigger bark/bite. Bonds, Stocks or the Dollar? After many years of equities and bonds rallying in tandem, central banks having stepped in to buy bonds to depress yields and bring down borrowing costs, and the cash being reallocated into equities for better returns, it’s interesting that the prices of both are now also reversing together. Bonds yields had already been rising (prices falling), but stock prices had still been rising. Now they are both back moving together. To the downside.

The question now is whether we are in for a joint reversal, or a reversal in bonds and a mild overdue correction in stocks? If so, now could represent great buying opportunity.

The old relationship would have it that equities are risk assets while bonds are safe and stable. So share prices should move opposite to bond prices, but in the same direction as the latter’s yields. In times of economic confidence, such as now, with central banks only daring tighten policy, because they believe their respective economies can handle it, following years of crises, perhaps we should be seeing bond prices fall, yields rise and equities favoured. But that was the old normal, before central banks unleashed unprecedented intervention. Does it still apply?

The problem now is that even if those selling out of bonds want to rotate back into equities, these remain at high levels, inflated by QE and then Trump-stimulus optimism, making it difficult to justify being in. Even if appetite for risk is still kicking around, have markets run out of fuel. Furthermore, might a bond market sell-off and newfound rise in bond yields do some of the central banks’ work for them by tightening borrowing conditions.

Could central banks risk over-tightening policy as growth improves, focusing on their inflation/unemployment mandates and old school models (which clearly don’t work anymore as none are fighting inflation) but ignoring the new market normals we are getting used to. Might they be the ones that jeopardise economic growth, and in turn both asset classes?

Food for thought, and if you want to more click here to join our research audience.

Enjoy your weekend.

Mike van Dulken, Head of Research, 2 Feb 2018