Hold your nerve – why there could be another leg up for equity markets in 2020 after bond yields turn negative

The collapse in bond yields seen this year could be a harbinger of strong performance for equities in 2020, Grace Lavelle, Director at River and Mercantile Solutions, has said.

Growth fears in the US and UK have spiked this year, with the corresponding performance of equity markets thus far in the fourth quarter mimicking the final quarter of 2018 as volatility spikes.

Investors’ fears have been exacerbated by the link between tumbling bond yields – which have moved into negative territory in some cases – and the onset of a recession. In some cases, the yield curve has also inverted, with longer-dated bonds yielding less than near-term debt, an event which is also taken as a warning sign for economic growth and equity performance.

However, Lavelle said inversions in the yield curve should not be relied on as an indicator of a recession and subsequent sell-off in markets.

“There are so many headlines around inverted yield curves preceding a recession, and clearly that is having an impact on market confidence as we start the fourth quarter, but we would caution against following that blindly as an investment strategy,” she said.

Indeed, tumbling bond yields can actually be a positive indicator for equity market performance. Historically, investors have seen average two-year equity returns of almost 30% after bond yields have seen their sharpest slumps, research from River and Mercantile shows. This is logical as lower yields act as a form of stimulus, supporting future equity market returns.

Given the recent falls in bond yields are some of the most extreme on record, Lavelle said it points to a promising 2020 for those still in the stock market. This expectation is supported by the various stimulus measures put in place not only in the US, but globally.

Lavelle noted that financial conditions have eased meaningfully over the last year, and while this takes time to take effect, she expects the stimulus to feed through to improving economic expectations as we move into 2020.

“Measures like PMIs are forward looking, and we think they are set to improve as we move into next year,” Lavelle said.

Changes in economic expectations tend to be the main driver of markets, rather than actual economics themselves. A modest improvement from current levels will be supportive for markets.

 “We would look to use any dips or sell-offs seen near-term to add money back into equities now as valuations look more reasonable. We think we could get another leg up for equities in 2020 as stimulus measures and the impact of significant falls in yields feed through into improving economics,” she said.

“Betting against equities in this environment has generally proven costly, and while we can certainly see weakness in the near term, there is a lot of support for equities being higher taking a 12-18 month view.”