BEWARE OF SIMULTANEOUS RISES IN STOCKS AND BONDS

Why Has Everything Been Going Up?

  • 25 February 2020
  • 15 minutes

Why is everything going up?

  • Central banks pushed newly “printed” cash into the financial markets in the wake of the financial crisis just over a decade ago

  • This sent the prices of stocks and bonds up together, which is not what we would expect to happen in a more traditional market environment

  • More recently, stocks and bonds in the US have been rising together even though the US central bank has ceased its cash injection programme

  • Or has it?

We’re watching the longest run of stock price rises (“bull run”) since records began. In the US, the S&P 500 benchmark stock index has risen by 360% since this run began in 2008 . Over the same period, the global bonds climbed by 45% . Normally you would expect one to fall while the other is rising. Something strange is going on. What is it? What normally happens Company shares are generally regarded as relatively high-risk rated investments, while bonds can be thought of as lower-risk rated investments. The higher the risk level, the more the price of the asset is likely to move. So in good times, investors will often move more money into shares to try to capture rising prices, while in bad times, they’ll move into bonds to try to reduce losses. As a result, when the demand for and prices of stocks are going up, the demand for and prices of bonds tend to fall, and vice versa.

The bull run

Back in 2008, the world was experiencing the worst financial crisis for around 80 years. Banks had lent too much money, people and businesses had borrowed too much and the supervisory bodies failed to take sufficient preventative action.

That left banks unable to lend money and people unwilling or unable to borrow. With much less money changing hands, demand for products and services slumped threatening employment levels and political stability.

Central banks, such as the Bank of England, European Central Bank, Bank of Japan and the US Federal Reserve (the “Fed”) had to take action. Their first step was to lower interest rates to make borrowing cheaper with the intention of encouraging higher spending, sales and profits.

It didn’t work. Interest rates were already very low, so they couldn’t be lowered far enough to make a significant difference.

All four of those central banks then turned to less conventional monetary policy in the form of “quantitative easing”. This is effectively printing new money but doing it electronically, then pouring that money into the financial system to boost lending, spending and sales.

How quantitative easing works

In very simple terms, a central bank has the authority to print new physical cash in its native currency (e.g. pounds for the Bank of England, US dollars for the Fed) or to simply add new numbers to its electronic bank balance. The central bank then uses that money to buy assets (usually bonds with very low-risk ratings) from commercial financial institutions.

For example, the Fed might offer to buy $500 billion-worth of government bonds at a higher price than they would otherwise sell for on the open market. That encourages banks, insurance and pensions companies to sell some of their bonds and make an instant profit.

The idea is that these financial institutions then use the cash they’ve received to buy other assets, spend on the business or lend to companies and individuals (for which they’ll charge fees and make a profit). That gets people lending, borrowing and spending again.

It took a couple of years, but quantitative easing did eventually work: the financial system creaked back into action, people started spending again, profits began to recover and share prices rose.

The side-effects

With central banks spending huge sums of money on bonds in particular, the prices of bonds rose considerably. This meant that the prices of both stocks and bonds were rising at the same time. Though historically unusual, that synchronised growth made sense while central banks were implementing quantitative easing.

There was a further factor. If you’re buying things, the total value of assets that you own will increase while your cash pile goes down (or your debt goes up). A central bank because it can print all the money it wants, it never runs out of cash. Therefore, as the central bank continues to buy bonds, the total value of assets listed on its balance sheet just gets bigger and bigger until it stops its quantitative easing programme.

The Fed reversed

By 2014, growth and inflation were at sufficiently high levels for the Federal Reserve to cease its third bout of quantitative easing since the financial crisis. Shortly after this happened bond prices and the Federal Reserve’s balance sheet both stopped rising, as one would expect.

A little later on, the Fed determined that the economic situation was sufficiently robust to enable it to start reversing the quantitative easing programme i.e. allowing the total number of assets on its balance sheet to fall “quantitative tapering”.

Sure enough, bond prices started to fall as the central bank’s demand ebbed. Meanwhile, because of the fairly positive economic outlook, share prices continued to rise. We were back in the traditional territory of stock prices and bond prices moving in opposite directions.

The chart shows how the Fed’s balance sheet has increased during its three quantitative easing programmes in 2008, 2010 and 2012. On each occasion, the prices of stocks and bonds have also risen, as one would expect. However, over recent months (circled in grey), the Fed’s balance sheet has been growing again while stocks and bonds rise in unison even though the Fed is not, officially, implementing quantitative easing.

Strange happenings

Then from October 2019, something strange started to happen. Stock prices were rising, continuing to be lifted by a generally positive economic outlook. That made sense. But bond prices started to rise as well. Following sustained quantitative easing, bond prices had become very high, making them unattractive during periods of economic growth. So why would demand for them increase?

Even though the Fed claimed that it had stopped its quantitative easing programme, the total value of assets on its balance sheet started rising again quite sharply. In other words, it looked like quantitative easing in all but name.

The Fed’s explanation

The Fed maintains that it has not been operating a new bout of quantitative easing. Rather, it says it has been doing its normal daily market intervention, but in a slightly unusual way.

Quantitative easing generally involves buying bonds that have several years left before they expire. What the Fed has been doing more recently is buying much shorter-term Treasury Bills (i.e. much like bonds, but lifespans of a few months rather than several years). They’ve been doing this because the cash-to-hand that commercial banks in the US hold to conduct day-to-day business had run very low. The Fed was buying Treasury Bills to top up those cash reserves and enable banks to keep running normally.

This daily intervention is standard practice. Some days the Fed buys Treasury Bills or the equivalent, other days it sells them depending on how much cash banks have. This intervention helps to keep things ticking over without too many changes in the amount of money in the system and, therefore, prevents sharp changes in interest rates from one day to the next.

However, the Fed’s latest bout of pouring newly created cash into the short-term trading markets has been going on for months without noticeable reversal. As a result, it appears to be having much the same effects as the more conventional quantitative easing.

Why investors should care

An investor with a diversified investment mix of assets such as stocks and bonds might have been enjoying the effects of Fed’s latest intervention. Both stocks and bonds have been going up in price, potentially adding value to much of what is held in a diversified portfolio. But this can’t continue indefinitely.

The recent outbreak of the coronavirus brought a temporary halt to the rise in share prices.

The more conventional relationship with bonds was restored: investors moved money from higher-risk rated shares (sending their prices down) to lower-risk rated bonds (sending their prices up).

Investors holding only company shares would have been vulnerable to a substantial overall loss in value across their portfolios. By contrast, investors holding a diversified portfolio would have seen some gains and some losses.

When the outlook became more positive in early February, company shares become more popular again while bonds were less in favour. Investors with a diversified portfolio would, once again, have been more likely to see their portfolios retain their overall value than that of someone who only invested in bonds.

Conclusion

There are two things to note here. Firstly, the importance of holding a diversified portfolio. Secondly, to be realistic about how long asset prices can go up.

We’re constantly looking for the next potential hiccup. It could come from a slowing of global growth or out of the blue from something entirely unpredictable such as the coronavirus. As we see near-term changes in the investing environment, we might make minor adjustments to the investments that we hold i.e. tactical asset allocation changes. But we believe that the majority of returns are dictated by the long-term investment decisions i.e. our strategic asset allocation policy. This is our view of how things are most likely to pan out over the coming 10 years or more.

And that’s why we don’t make big shifts in investments from stocks to bonds or vice versa: even when the immediate outlook might appear quite negative, the longer-term outlook probably hasn’t changed much, so we keep the short-term adjustments to fairly modest levels.

Forecasts of future performance are not a reliable guide to actual results in the future; neither is past performance a reliable indicator of future results. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed and the investor might not get back their initial investment,

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