Stocks and bonds: twin peaks

Mid-Week Bond Update

Stocks and bonds: twin peaks

World benchmark US stocks and government bond prices reached or hovered around record highs over the past five trading days, lifted by potential tax cuts and hopes of continuous easy monetary policy. The election of Jerome Powell as Federal Reserve (Fed) chairman was cheered by some bond investors, on expectations his policies will be as cautious as...

present chair Janet Yellen’s. US president Trump’s trip to Asia also tempered recent bouts of political uncertainty, mostly led by Saudi Arabia’s crackdown on corruption and an increase in tensions with Iran. But the negative effect of the arrest of dozens of Saudi princes, ministers and former officials was largely offset as Trump shook hands in China – a trade enemy barely one year ago. Oil rallied to US$ 56.8 per barrel, from $54 at the end of last month, on prospects of higher demand and also on the back of the recent Middle East tension.

The US dollar rose, having now offset its summer dip. As a result, Emerging Market (EM) currencies fell, especially the Russian ruble, which plunged almost 2% over the past five trading days following the fifth interest rate cut this year – a move to reignite growth. Disappointing Chinese data in October, including below-expectations Imports, Exports and Manufacturing Purchasing Managers’ Index, also weighed on the asset class. Economic data disappointed in Europe, with Germany’s September Industrial Output down 1.6% and Eurozone inflation 0.1% lower in October. European sovereign bond yields, also supported by the European Central Bank’s monetary stimulus programme, fell. On the other hand, UK interest rates rose for the first time in a decade as the Bank of England aims to stem rising inflation. The central bank hinted at the possibility of further hikes – but the comments were largely ignored by investors (read more below).



Stocks and bonds: with a little help from the Fed: US equities continued to reach new heights as investors maintain faith on Trump’s ability to deliver his proposed tax cuts, and as positive third-quarter earnings surprises (73%), surpassed the negative ones (20%). Treasury bonds also rallied, despite strong jobs data, on prospects that monetary policy will remain accommodative under new chair Jerome Powell. As seen on the chart, easy central bank policy has been closely correlated to the surge in stock and bond prices since the Fed unveiled its multi-trillion dollar stimulus following the 2007-08 financial crisis. But, as seen on the second chart, the country’s yield curve is showing a far less rosy picture: the difference between 5 and 30-year Treasury yields reached this week its lowest level in ten years – a sign that investors do not expect strong growth and inflation down the line. Click here to read the views of the Western Asset’s Chief Investment Officer Ken Leech over excess market optimism, and pessimism.


Stocks, bonds and the yield curve: different stories 

Second chart shows the difference between 30 and 5-year Treasury yields

Source: Bloomberg 8 Nov. 2017. RHS is Right Hand Side. Past performance is no guarantee of future results. Please see disclaimers for definitions.


UK wages – home alone? As the winter settles in, Britons welcomed data showing that wages are increasing, a relief after suffering months of rising inflation, sluggish growth and high uncertainty over the country’s planned departure from the European Union. The wage increase, however, has been linked to a drop in the availability of workers, which could reflect the country is attracting fewer, Brexit-deterred foreign nationals. Adding to the woes, the Bank of England’s Agents’ Summary of local businesses also highlighted expectations of weaker spending growth over the next two years. Business owners said economic uncertainty was the biggest drag on plans. Mirroring this gloom, the pound has weakened 1.4% against the US dollar so far this month – the worst performing developed market currency.



EM currencies (not returns): Most EM currencies dropped against a rising US dollar over the past five trading days, hitting EM local sovereign bond indices, which otherwise would have remained flat over the period. The currency drops were bigger in Europe, dragged down by a lower euro, than in Latin America, where the Colombian peso and the Brazilian real, for instance, rallied on the back of surging oil prices. Despite the currency drop, foreign exchange still weighs less on leading EM bond indices than other factors, such as the interest earned by fixed income securities. As seen on the chart, the benchmark JP Morgan GBI EM Broad index of local sovereign bonds has returned 8.45% so far this year – with 4.6% attributable to interest and 3.5%, to currency. While the interest contribution is relatively stable across regions, it is the foreign exchange factor that has positively lifted returns in Latin America – or dragged them down in the Middle East and Africa. Click here to read Brandywine Global’s blog: A tourist’s guide to currency management.


Interest outweights currencies as a return contributor (YTD % change, by contribution, for the JP Morgan GBI EM Broad index of EM local sovereign bonds)

Source: Bloomberg as of 8 Nov. 2017. USD is US dollar. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


Move Index – not moving: The MOVE index that tracks volatility in Fixed Income markets fell this week to its lowest level since its 1988 inception. Decreased geopolitical tension around North Korea and the diplomatic gestures of US president Trump in China – a trade enemy only one year ago – have contributed to the reduced stress in capital markets. The news, however, may not be as positive as it sounds as volatility tends to increase trading opportunities, especially for derivative assets. As mostly everything in bond markets: good news may be bad news.


Source for all data: Bloomberg and Barclays Capital as of 8 November 2017, unless indicated.


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.