AFTER a shaky start, last week saw the second quarter US earnings season come alive and galvanise equity markets. The strong rally that began on Thursday was thanks to better-than-expected bottom line, top line and forward guidance from bellwether stocks such as Caterpillar, UPS, Microsoft and 3M. But it also highlighted a contradiction that is becoming increasingly obvious – an apparent improvement in the corporate sector against a weakening economic background. If the macro picture was improving, we wouldn’t have heard such downbeat testimony from Fed chairman Ben Bernanke last Wednesday when he warned of an unusually uncertain outlook.
The disparity between the corporate outlook and the wider economy is highlighted by the correlation between equities and bonds. The yield on the two-year Treasury has been hitting new lows while the 10-year yield is well below 3 per cent and fell to 2.86 per cent last Wednesday. This means that equities and bonds are rallying at the same time – a situation that can’t carry on indefinitely. Low yields typically indicate expectations of a weak economic environment, which should weigh on the corporate sector. Some analysts argue that without government stimulus, equities would be much lower while the yield curve could be inverted if the Fed allowed the base rate to trade at its true market level.
The strength of US stocks is also surprising given the amount of money leaving equities and finding its way to the bond market. For the week ending 14 July, the Investment Company Institute (ICI) estimates that more than $3bn left equity funds, while $5.8bn found its way into bonds. So while this helps to explain recent bond strength, it is at odds with an equity rally. Year to date, $37.5bn has left equity funds, yet the S&P is pretty much unchanged from the end of 2009.
While the actions of governments and central banks are distorting the historical correlations between financial instruments, in time these relationships will return to normal. The question for investors is which market to trust most, bonds or equities?