Bond proxies will not save investors

What does well when the world’s most powerful man writes a furious tweet, followed by real life decisions that send stock market plunging? Bonds. But if you are still exposed to equities, where is the best place to be? Bond proxies.

This, at least, has been the scenario so far. But investors are forgetting that companies less dependent on the business cycle are not completely immune to economic turmoil.

Late last week, after having tweeted a zillion times about how unfair it is that the rest of the world is sponging off America’s economy (conveniently forgetting about the ‘exorbitant privilege’ conferred by the dollar’s reserve currency status), President Trump announced new tariffs on more imports from China.

This came just after the Federal Reserve lowered the interest rate by a quarter of a percentage point, the first rate cut by the Fed since 2009.

In the decade since the global financial crisis, the so-called “deflation assets” – government bonds, investment grade corporate bonds, US high yield debt, as well as the S&P 500 and US consumer discretionary stocks – have outperformed inflation assets like real estate, commodities or bank stocks, according to analysis by Bank of America Merrill Lynch.

This year, bond prices hit a record high and so did inflows into bond funds. The Fed’s latest rate cut will pour even more fuel on this flame. Combined with the uncertainty created by President Trump’s rather chaotic trade policy, this makes it likely that investors will keep chasing safe havens.

In other words, interest rate cuts are usually bullish for stocks, but this one may not be.

Andrew Lapthorne, equity strategist at Societe Generale, is not known as an optimist, but he always backs up his gloomy views with solid figures. In recent research, he showed how bond proxies – stocks with high correlations with bonds – have risen during this market cycle, whereas cyclical equities have been lagging behind.

Bond Proxies vs Cyclical Stocks

The Fed’s latest rate cut will pour even more fuel on this flame.

Lapthorne also showed that current global market cycle “has been driven almost entirely by valuations and not profits”.

The US had been the exception to the poor profit narrative, but looking at recent revisions to corporate profits, he concluded that even in the US, profits have not grown since 2014.

This means that “a big gap has opened between quoted sector EPS numbers, which look very healthy, and whole economy data, which does not. History tells us the whole economy data tends to lead quoted sector profits by a year and is usually the more accurate.”