A bull market in everything
One of the key principles of investing - diversification - works because different assets do well in different circumstances. Broadly speaking, shares go up when the outlook improves, and investors are more optimistic. Bonds, on the other hand, rise when the economy deteriorates. In uncertain times, investors are attracted by the promise of a fixed income and a more reliable capital return.
Because no-one knows what lies around the corner, a balanced portfolio holding both shares and bonds reduces the risk of getting it wrong. Living to fight another day should be a key objective for any investor - or as Warren Buffett puts it: rule number one, don’t lose money.
So far in 2019, markets have not followed this simple roadmap. Shares and bonds have both risen strongly at the same time. Add in the continuing rise of commercial property prices and a resurgence of interest in gold and a higher oil price too and we have a pretty unusual state of affairs. There’s been no benefit in diversification this year because we’ve experienced what Goldman Sachs recently described as a ‘bull market in everything’.
It’s been one of the strongest starts to a year since the 1960s with a simple portfolio holding 60pc in shares and 40pc in bonds delivering a return of 15pc with relatively low volatility. This is good news for anyone holding such a portfolio, but also a bit confusing. Surely, optimistic equity investors and pessimistic bond buyers can’t both be right at the same time? One of them must be engaged in wishful thinking.
Actually, in the short term, there is method in the market’s apparent madness. The rallies in both share and bond prices reflect a dramatic U-turn at the Federal Reserve at the beginning of the year. The US central bank moved in a matter of weeks from planning for a continuation of the interest rate rises that it started in 2015 to indicating that rates will fall both this year and next. The smart money is now looking for interest rates to reduce by one percentage point over the next year or so. Given that the Fed Funds rate is only between 2.25pc and 2.5pc, that is quite a reversal.
This is good news for bond prices because if investors are prepared to accept a lower yield, in line with the risk-free return from cash, they will, as a matter of simple arithmetic, be willing to pay more for whatever fixed coupon they receive from a bond. The yield on a 10-year Treasury bond is now just 2pc compared with nearly 3.3pc a year ago.
At the same time, the fundamental worth of a share is determined by the value today of all its future cashflows. When interest rates fall, the implied present value of those deferred cashflows is higher. This is why share prices have risen to new highs despite the long list of things to worry about in the world, from trade wars to sabre-rattling in the Middle East.
However, if you think about it, both of these technical explanations are fundamentally quite pessimistic. Falling interest rates can boost both bond and share prices in the short term, but when you ask yourself the reason why rates are being cut it’s harder to remain positive. The Fed changed its tune at the beginning of 2019 because it realised that it had over-estimated the impact of the stimulus from Donald Trump’s tax cuts and it had worried too much that historically low unemployment would feed through into higher inflation. Fed chair Jay Powell told Congress last week that the growth outlook has deteriorated.
When you look beneath the surface of the recent rally in share prices - to a new all-time high of 3,000 in the case of America’s S&P 500 - the bull market also has a surprisingly bearish feel. When you look at the sectors that have been outperforming recently, it is clear that the shares that benefit from long-term structural growth stories have done much better than so-called cyclical stocks that benefit from an increase in economic activity. Financials have been weak. There has been a flight to quality.
It is troubling, too, to look at where investors are putting their money to work. Over the past six months, flows out of US equity funds have been as large as they were during the global financial crisis, while money market and bond funds have received big inflows.
It’s often said of investment that it is better to travel than to arrive. The expectation of a change in policy by the Federal Reserve provided the justification for reversing last autumn’s stock market rout. No-one will now be pleasantly surprised by a cut in US interest rates at the next Fed meeting at the end of the month. It is well understood and priced in. The danger now is that the Fed under-delivers or that the growth which interest rate cuts are designed to encourage fails to arrive.
More than 90pc of the rise in shares this year has been down to investors’ willingness to pay a higher multiple of earnings rather than a rise in the actual level of those earnings. That is typical when interest rates are expected to fall. It has happened almost every time rates have been cut in the past. But this rising appetite for risk will only be sustainable if the Fed cuts as much as investors hope and if growth follows through as expected.
This is no counsel of despair. It rarely makes sense to ‘fight the Fed’ and lower interest rates are certainly on the way. But it is a call to be cautious - to hold some cash, to go for quality, invest in companies that are less sensitive to economic growth, and to be well diversified. It hasn’t mattered so far in 2019, but it might soon.
Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63.
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