David Morris

WHILE July was a good month for most stock indices, August has been pretty grim so far. An early rally faded as the S&P encountered significant resistance around 1,130. Equities have struggled to make headway ever since and low trading volumes have exacerbated intra-day market moves. Yet most indices are range-bound and are likely to stay so until after US Labor Day on 6 September. The relentless flood of weak US economic data had investors geared up for further stimulus. But the Fed’s eventual decision wasn’t the move that many had hoped for. The news lifted bond prices, but caused a sell-off in equities.

Record low bond yields are fuelling speculation of a fixed income bubble. Although the bond bull market has lasted nearly 30 years, there are good reasons why yields may stay depressed. For a start, the Fed is unlikely to raise rates anytime soon. Indeed, they continue to buy bonds to try to keep yields down across the curve. Private sector deleveraging is depressing the housing market and economic growth, while corporate cost-cutting and high unemployment ensures wages are static or falling. What’s more, the large tranche of baby boomers on the verge of retirement are desperate to retain their pension pots. They want their principal back and the promise of higher dividend yields in certain stocks can’t compensate for falling share prices. Furthermore, dividend payments on equities aren’t assured, in contrast to bonds – unless the issuer defaults.

The danger is that the “long bond” trade is getting crowded even as deflation becomes a real possibility. Yet equity markets haven’t priced the deflation risk in. No doubt many investors are looking at central bank monetisation and see the eventual return of inflation which will destroy bonds. But in the short-term, something has got to give – the “bonds-versus-equities” debate will be settled sooner rather than later.