With the benefit of hindsight, investors who panicked and sold off during the last quarter of 2018 fared the worse. The change in central bankers’ tone of voice, in December last year, gave markets a well-needed boost. Sovereign and corporate bond holders, together with equity investors, accepted the news with open arms. Central banks’ dovishness remained rather firm in the first six months of the year. As a result, this year has in general been a boon for both risky and safe assets. This is not a usual occurrence, when different investors have different views on the world economy.

By now, we have been accustomed to the positive market reactions when central banks indicate that more financial assistance, or monetary easing, will be given to economies as economic figures disappoint. The easing of monetary policy, through lower interest rates, is usually one way how central banks support their economies. In recent years, quantitative easing (QE) has become one major tool used by various central banks to stimulate economic growth. In short, QE is the injection of money in an economy through financial markets, as a central bank buys back bonds from the secondary market, injecting money in bond holders’ pockets and pushing yield lower in the process.

Last week, the much awaited forward guidance from the US Federal Reserve (FED) and the European Central Bank (ECB) did not disappoint. Once again we witnessed a rally in both high quality bonds and risky assets, such as fixed income and equities. While economic and inflationary figures are generally missing targets, investors’ focus is highly tilted towards the means and tools central bankers have at hand to lift economies from a low growth and low inflationary environment. Over the past three years, the FED and the ECB took different monetary policy paths, as US economic growth improved together with lower unemployment. In Europe economic growth remained sluggish. In other words, while interest rates were on the rise and QE on the decline in the US, the situation in Europe was pretty much the opposite. The ECB cut short-term rates to below zero, by 40 basis points, making it more expensive for banks to hold cash.

Following last week’s central banks’ meetings, negative yielding bonds are back in the spotlight. Mario Draghi’s dovish speech on June 18 sent bond prices even higher (yields lower), as he hinted that the ECB could provide further stimulus if downside risks increase and inflation figures continue to disappoint. On the news, bond yields declined globally with over $12 trillion worth of bonds trading at negative yields.

In the US, the FED also sent dovish signals as the statement from last week’s meeting emphasized higher economic uncertainty. Based on this, almost half of the members who sit on the committee, which decides on interest rates, are now forecasting a 50 basis point rate cut by the end of this year. In addition to this, according to FED Chairman Jerome Powell, those who do not forecast a rate cut so early, do believe that there is room for monetary easing.

Locally, the impact of last week’s central banks’ announcements had a positive impact on the value of local government bonds (MGS). The 10-year MGS is now trading around €144, up from €136.79 in the beginning of January. The same bond is yielding 0.65%, down from 1.40% in the beginning of the year. Similarly, the yield on the 20-year MGS declined from nearly 2% in January to 1.28% this week. In addition, the nominal value of local bonds, which are now trading at negative yields, shot up from €700m in the beginning of the year, to over €2 billion this week.

But why do markets rally when central bankers indicate that more monetary assistance is on the way? In a textbook scenario, lower interest rates and more money injected in an economy will lead to more capital investments undertaken by businesses, higher corporate and household borrowings, more spending, more disposable income, increasing demand for goods and lower unemployment. Out of the two central banks mentioned in this article, the US got the closest to this, hence the interest rate differential between the two economies.

Some weeks ago, we wrote about the fact that both equities and high quality sovereign bonds have generally moved higher this year – a topic which gained further attention lately. While this has happened in the past, it is not the norm to see significant gains in equities when yields on safe assets are declining. An environment of declining yields (higher demand for sovereign bonds) is usually associated with future economic slowdown. If lower interest rates are the solution to the current low economic growth, then the positive performance in both high quality bonds and equities is justified. However, in a recessionary environment, bonds may have further upside while equities decline.

We do not believe in an imminent recession, yet we are mindful that economies do go through phases, and slowdowns do occur. While investing in equities carries risks and may add to portfolio volatility, it is paramount for investors to understand that it is riskier having a portfolio fully invested in the highest income-yielding assets. A low interest rate environment may push investors further towards riskier fixed-income assets, to generate the same income yield they did some years down the line. Adopting a flexible investment approach with a focus on total return performance, against focusing solely on income yield, is paramount in an environment when income returns are low, and may remain at these levels for longer.

Gabriel Mansueto is Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited on Tel: 2122 4410, or email [email protected]