EQUITY INVESTORS SHOULD HEED MESSAGE FROM COMMODITIES AND BONDS / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

December 1, 2014 6:22 am

Equity investors should heed message from commodities and bonds

Mohamed El-Erian

Hard to find reasons for divergence between asset class prices

 

It is that season again when commentators review the year’s developments and what they imply for next year. A big surprise is the extent to which record equity prices have diverged from declining commodity prices and unusually low yields on government bonds. This historically unusual divergence can no longer be explained by big macro factors, and the bespoke explanations will be harder to sustain the greater the divergence as we enter 2015.

Had 2014 closed this past weekend, investors in US equity markets would have earned 12 per cent (as measured by the S&P 500). Meanwhile, commodity investors would have lost 9 per cent (as measured by the Thomson Reuters Commodity Index) at a time when the yield on the 30-year US Treasury bond has fallen 100 basis points to 2.89 per cent.

 

This historically unusual configuration has been particularly stark since the last mini market correction. From mid-October, equities have surged almost 11 per cent while commodities have fallen 7 per cent (amplified by last week’s dramatic plunge in oil prices) and the yield on the 30-year bond is slightly lower. And all this despite three factors.

First, equity rallies that include a series of record highs after an impressive multiyear advance, which has been the case this year, are usually underpinned by robust economic growth. While economic performance has improved in the US – see last week’s revised economic growth rate of 3.9 per cent and the steady decline in the unemployment rate to 5.8 per cent – it remains below what is needed to recapture the foregone potential of recent years. And it is facing increasing headwinds from slowing growth in Europe, Japan and emerging economies, where many US companies sell.

Second, to the extent that improved US economic performance could justify equity valuations, and it is a bit of a stretch, this would conflict with the message coming from bonds and commodities. If anything, the latter points to faltering growth overall.

 

Third, the other holistic explanation, relying on the influence of experimental central bank measures, is also becoming less powerful.

Undoubtedly, unconventional monetary policy became the most important determinant of asset prices following the 2008 global financial crisis, overcoming the influence of fundamentals and altering many historical market correlations in the process. Its repeated success in repressing market volatility and quickly reversing any price hiccup armed investors with the confidence to run well ahead of central banks’ attainment of their policy objectives.
 
The influence of policies on asset prices could become more ambiguous now that central banks are no longer all going in the same direction. The ECB, Bank of Japan and Bank of China are increasing stimulus while the Federal Reserve is heading in the other direction.

A bespoke approach provides a better explanation of the growing divergence between equity, bond and commodity markets. After all, equity prices receive support from share buybacks and dividend hikes, both enabled by the deployment of the cash held on companies’ balance sheets.

Meanwhile, the hunt for yield forces fixed income investors to double up on their investments in virtually all securities. Commodity prices are also under pressure, most recently due to Opec’s decision not to lower its output ceiling, but also from alternative energy supplies, together with a change in composition of global growth that favours countries with less intensive use of commodities per unit of GDP (eg, an improving US versus a slowing China that recently has played the role of a marginal price setter for several commodities).

 

Yet even such individualised reasoning will be challenged should the divergences of recent months widen further. At some stage in 2015, market correlations will probably revert to a pattern that is warranted by economic and policy fundamentals. However, what that proves to be is an open question as it depends heavily on what happens to growth and policy effectiveness.

Should 2015 fail to involve both a meaningful increase in global growth and more comprehensive policy responses, equity investors will regret not paying greater attention to the messages coming from their counterparts in the bond and commodity markets.


Mohamed El-Erian is chief economic adviser to Allianz and author of “When Markets Collide”