Elevators, escalators and markets

Understanding the relationship between interest rates, bonds and equities, writes

With all of the noise affecting markets, investors remain focused on central banks and the trajectory of inflation and interest rates.

The interest rate cycle is different now in terms of the speed at which central banks have hiked interest rates to tame inflation.

For many years, the saying was that the US Federal Reserve takes the escalator up and the elevator down — in other words, it raises interest rates slowly until inflation stalls, and then cuts rates quickly. But this cycle — with 11 rate hikes, including four consecutive 75 basis point

(bp) hikes and two 50bp hikes — has taken the elevator up.

So recent CPI prints that disappointed by seeming to indicate sticky inflation suggest that the Fed’s preference will be to take the escalator down. Some fear rates could even be hiked still more, but this seems a bit of a stretch — after all, for the first time in many years the Fed is running real rates of about 2%. Barring total disaster, that should eventually choke inflation off.

How concerned should one be about this whole cycle? A lot of stock market observation, commentary and investment policy has been reduced to “interest rates up, equity markets down” and vice versa. If you are an intermediate-term investor (one- to five-year horizon) that is going to be your primary area of concern. For a longterm investor (10 years), the focus needs to be more on earnings.

When earnings go nowhere, so do entire equity markets. As South Africans, we not unreasonably engage in self-pity as our asset markets struggle. But there is a much more famous basket case: China. Despite enormous economic gains, which the populace has benefited from, investors have not done so well. The reason is lack of earnings growth on a per share basis, both long term and in recent years. Why this is so is the subject for another discussion, though the

Chinese government tends to meddle in business.

My two slightly dated MSCI China graphs (sources: Ed Yardeni and Schroders from Refinitiv) show some educational results: investment and earnings from the start point were poor; investment and earnings growth from the 2000 low were excellent; and markets ignored the earnings picture flattening from 2012 and paid a heavy price. Economies can grow like Topsy and still be lousy to invest in if shareholders are badly treated.

It would be churlish not to note that the Shanghai index has done better compared with the 1990-2000 period, but the basic idea stands.

Even the intermediate outlook for China is suspect. Economic growth continues, but the government takes a heavy-handed approach with business, while its monetary policy remains restrictive even though the economy suffered extensive choking from the mismanagement of the Covid debacle.

I’m sure there are some on the Left who consider it fine if the economy has done well at the expense of business. Nevertheless, a big part of China’s growth has been driven by the distorted demographics caused by the one-two of high population growth demanded by Mao, followed by the one-child policy. Without good-quality investment market results, Chinese pensioners could

The relationship between repo rates and bond markets is close but far from perfect

Both equity markets and bond markets tend to take views on future returns that will be driven by the impact of central bank operations on the inflation rate

face a dismal future.

I’ve seen a lot of fund managers punting China as cheap. Nah — I’ll give it a miss until President Xi Jinping and others have an attitude change towards business.

This rather spectacular case study having demonstrated the long term, I turn to the intermediate term. First, investors need to distinguish between central bank-driven repo rates and bond markets. Equities evaluation does entail relating prospective returns on equities back against the returns available from the bond curve.

The relationship between repo rates and bond markets is close but far from perfect. Both equity markets and bond markets tend to take views on future returns that will be driven by the impact of central bank operations on the inflation rate. Certainly, heavy-handed repo action could both constrain earnings and cause the hurdle rate of return for equities to be steeper (thus depressing their cost price).

The tendency of equity markets to need to process earnings is probably a big part of why they tend to lag bond markets in the interest rate and economic cycle. It’s often said that bond markets are smarter than equity markets, but I doubt that that is true, and it’s more a case that they are swallowing and digesting different information pills.

This leads me to ask how bond and equity markets correlate with each other. The featured graphs (hat tip to 10X Investments) show the relationship dynamics of bond vs equity returns over the years. In the case of South Africa there is a positive relationship between bonds and equities, and this is quite normal (in geographic and time terms) for an environment of moderate inflation. In recent times you will see that the relationship has become even tighter as South Africa Inc angst has worsened.

In the US chart we see that between 2000 and 2021 the relationship was inverse. This curious phenomenon is called “Gibson’s paradox” (and was originally observed in inflation/wholesale price studies). It tends to arise when long bond yields drop below 2.5%.

The reversion of the West to a more inflationary environment means that once again bond and equity market returns are more in sync. This might seem academic, but it has important implications for portfolio returns and diversification.

First, in a normal environment, the old Fed model was a not unreasonable depiction of fair market value, but it fails utterly under deflationary conditions. Second, when Gibson’s paradox is in play, 60/40 global portfolios typically have reduced volatility because the bond diversifier is so effective.

While this diversification will still be important for portfolio risk management in future, thanks to the swing in global inflation, managing risk in balanced global portfolios just got tougher.