Follow the smart money into bonds, not stocks

Which asset is a better bet going forward: Stocks or bonds? The answer depends on your view on the economy and inflation.

There is a long list of indicators pointing to the fact that the economy is in the best shape it has been since the Great Recession. New house sales and prices are rising on both side of the border, car sales are booming and surveys show that consumer and small business confidence is rising. Business and governments are hiring again. Unemployment is dropping fast.

At the same time, inflation is back. Consumer price indexes in North America have registered above or at key target levels for the first time in years. Normally, accelerating economic growth and a falling unemployment rate tend to go hand-in-hand with rising inflation, and so it is not unreasonable that investors have started to worry about inflation and its potential threat to the markets.

How is the smart money responding? By buying not only real-return bonds but also nominal long bonds, betting that the pickup in economic activity is a mirage and that inflation fears are overstated.

Let me back up and explain. The nominal interest rate is the reward one expects for making an investment and has three parts. First is the reward for postponing consumption for the future, i.e., the real interest rate; second is the reward for possible loss of purchasing power, i.e., the premium for expected inflation; and third is the reward for possible loss of capital, i.e., the risk premium. (I will ignore the risk premium here as it does not normally apply to government bonds.)

In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts, the real interest rate falls.

In May, 2013, Canadian government long bonds registered a decline of 3.1 per cent. U.S. Treasury bond prices declined even more, prompting many analysts to scratch their heads since inflation was nowhere to be found. At the time, I said inflation and inflation expectations had nothing to do with the declines. Instead, they were related to an increase in real interest rates prompted by signs of an improved economy in the United States.

Fast forward to this year. One of the best-performing asset classes in recent months has been real return bonds. The iShares Canadian Real Return Bond prices have risen by over 10 per cent since December, 2013. Government of Canada nominal bonds, represented by the iShares Canadian Government bond index, are also up, but only about 5 per cent over the same period, whereas the iShares Canadian Long Term Bond Index is up by about 9 per cent.

One can argue that real return bond prices are rising because inflation expectations are accelerating – as these bonds are supposed to be a good hedge against rising inflation. But then why are the nominal government bond prices also rising?

The reason may have less to do with inflation and more to do more with the fact that the economy is going to decelerate from this point on. If U.S. and Canadian economies were on an upswing, that would put downward pressure on real return bond prices and upward pressure on real interest rates. This is not happening.

If the smart money is right, the outlook may be better for bonds than stocks. While continued low interest rates will support stock and bond market valuations, low economic growth will strain company growth and profitability, creating a drag on stock valuations.

George Athanassakos, gathanassakos@ivey.uwo.ca, is a Professor of Finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario. He is also the director of the Ben Graham Center for Value Investing.