It has been another year where traditional balanced portfolios are delivering attractive returns, with both global equity and bond markets rising 5.5 per cent and 4.6 per cent respectively.
We caution against assuming this trend is sustainable on a continuous basis, particularly the phenomenon that both major asset classes can continue to rise at the same time.
While gains from both equities and bonds are welcome, equities reflect a positive economy with low risks while bonds signal a weak economy with high risks.
In the past when this has occurred, one of the markets usually ends up correcting as the economic path plays out.
The strength of bond market returns has been the surprise this year, with many investors caught on the wrong side.
So, how long can equity and government bond prices rise together?
We would argue this has a very limited lifespan now. Further declines in developed market bond yields would indicate the majority of them are pricing in a move back towards recessionary territory.
It is difficult to see a further re-rating of equity markets in this environment. Given our outlook of an ongoing gradual economic recovery, our expectation is that the change in behaviour and market correction is more likely to occur in the bond markets.
It is a dangerous time to get dragged into the fixed income rally now. Without overly focusing on the valuation headwinds for bond markets, the fundamental scenario that bond investors are predicting remains a concern.
With bonds already pricing a weak economic outlook, re-allocating to bonds today implies first a high expectation that this outcome will materialise and second that it will be likely even worse than already priced in.
There are a number of ways to assess how bearish bond managers are. If we look at the US, longer-term bond yields (10-year yields at 2.5 per cent at the time of writing) are well below trend nominal GDP growth – currently 1.2 per cent below.
This is three times the historical average. At the shorter end of the yield curve in the eurozone, the story is similar. The market is not expecting the European Central Bank to raise rates until after 2016 with negative real rates priced in until the end of the decade.
Investors talk about a potential Japanese situation (one of economic stagnation) being priced into the eurozone economy but arguably this is already the case. The main point here is that bond investors are very bearish, and in our view overly so.
In spite of our concern for bond markets, we do not expect a material correction in a short time period, but rather a gradual rise in yields towards levels lower than we have had in the past. A key issue for multi-asset investors is how equities will perform during this expected rise in bond yields.
Ultimately, this will depend on the pace of the move in yields, the drivers behind it and the level to which they rise. For now, we expect equities to continue to be able to make gains as yields rise, with the correlation between equity and bond prices shifting from positive to negative.
For a rise in sovereign bond yields to derail equity markets, we believe yields need to move to levels that either threaten the relative valuation support for equities or, more importantly, levels which weigh on the growth outlook for the developed world, particularly the US.
As equity markets continue to re-rate, we believe that until bond yields are above 3 per cent, neither the valuation case nor the impacts on growth are major concerns.
At 3 per cent, that is still more than 50 basis points above current levels. While equity investors may watch bond developments, they should not be scared of them just yet.
Toby Vaughan is head of fund management, global multi-asset solutions at Santander Asset Management
