Examining the correlation between equity and bond markets

While equities and bonds have both posted solid results so far in 2019, such parallel performance isn’t typical, leaving investors to consider which one of these markets will be the first to decidedly reverse course.

For example, returns for the S&P/TSX Composite are more than 13% year to date; for the FTSE Canada’s all corporate bond index, more than 5%.

An optimistic equity market is signalling economic improvements since the year began, said a weekly markets insight report from Richardson GMP, while falling yields imply global economic growth may be decelerating faster than anticipated. Which market is correct?

For equities, tailwinds from earlier in the year might be played out, the report suggested. These include a cheaply priced market after last year’s fourth-quarter sell-off, a Fed that backed off its rate-hiking path and lower bond yields that helped fuel higher stock prices through multiple expansion.

With these equity-friendly developments largely in the rearview mirror, economic data will likely be more important to the markets in the coming months (outside developments in the U.S-China trade conflict), the report said.

For example, softer economic data would result in bond yields continuing to fall, with equity markets responding defensively. With positive economic data, yields would grind higher, consequently creating a “very strong tailwind for equities given still-reasonable valuations, yields rising from a low base and improving optimism for earnings growth,” the report said.

So far this year, global economic data has mostly disappointed and will weigh on market confidence if it continues to do so. “The next few weeks will be crucial with global manufacturing data releases, consumer confidence and labour reports,” the report said.

In Canada, economic data has surpassed expectations recently in many instances, including jobs growth, retail sales and wholesale trade.

“Pretty much since the day the Bank of Canada delivered a downbeat economic forecast at its April [monetary policy report], we have been fed a steady diet of strong Canadian data,” said BMO chief economist Douglas Porter in a weekly financial digest.

While he expects first-quarter GDP numbers (released this Friday) to be “quite sluggish,” BMO revised upward its call for Q1 GDP to 0.5% annualized and expects “significant improvement” in Q2, at 2.3%, Porter said.

The BMO report also considered how a U.S-China trade war would negatively affect Canadian growth, estimating that a 0.6 percentage point dip in U.S. growth could pull down Canadian growth by about 0.3 percentage points—a meaningful drop.

Trade uncertainty alone could “chill business investment,” which has already been a notable laggard for much of this cycle globally, Porter said.

Noting that equities have receded in May, he described investors as starting to shift their perspective on trade to a base case from only an outside risk. Given the tone from both the U.S. and China, “this seems to be a prudent step,” he said.

For full details, read the reports from BMO and Richardson GMP.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.