This week we have been focusing on a new tactical trade idea for Qantas. We…
Historically, bonds and stocks move inversely to each other, and while this hasn’t always been the case, this relationship has held in recent years. However, as with most rules, it is not without exceptions.
Broad macroeconomic conditions factor into the Reserve Bank of Australia’s (RBA) decisions on the RBA Official Cash Rate and affect investors’ risk appetite. Bonds and stocks are competing for a limited amount of capital and when the economy moves, these markets tend to trade inversely. To understand this relationship, it is important to have a grasp of the business cycle (figure 1) and the long- and short-term effects of the RBA’s actions.
Figure 1. Long-Term Business Cycle
When the economy is going well or showing signs of improvement, stocks tend to rise as investors try to get a piece of strong corporate profits. This generates higher market returns for equity (i.e. ROE) which attracts investors higher equity allocations and lower allocation to lower risk, lower-yielding bond markets due to the risk-on sentiment in markets.
This equity increase coupled with the inflation risk generated by economic growth, with higher corporate profits, higher wages and accordingly, higher profits. However, to curb inflation the RBA will generally lift interest rates, which serves to reduce rates. As rates rise, newly issues bonds are offered at the current (higher) market rate and will pay a more attractive coupon, increasing demand due to a more competitive yield.
In contrast when the economy is showing signs of weakening, investors become more risk-averse and markets see a flight to safety in the form of lower risk, lower return instruments. To spur investment and economic activity, the RBA will usually lower the cash rate to bolster economic spending and support economic growth in the economy.
There are periods when bonds and stocks are positively correlated. When inflationary pressures are weak, and the RBA is steadfast in keeping interest rates on hold, we often see fixed income and equity markets move in-sync. This was seen last year as both domestic equity and credit markets struggling to perform amid late economic cycle pressures and broader factors including the US-China trade war and Brexit concerns.
The relationship between bonds and shares is seen by many to be a sign that change is on the horizon in the global economy. Rising bonds prices can be a signal that investors are growing pessimistic about the future economic environment or the stock markets valuation and we’ve seen throughout 2018 that volatility can occur suddenly and dramatically, such as the February VIX explosion (figure 2).
Figure 2. Historical VIX Volatility (2017 – 2018)
Source: BondAdviser, Bloomberg
The key for investors is to manage these risks through tactical security selection and strategic asset allocation to create a more robust portfolio throughout 2019 and beyond.