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In recent weeks, investors have been puzzling over stocks rising while bond yields fall, responding differently to the same economic data.

A report from Richardson GMP noted the “magic combo” of lower yields and dovish central banks enabling equity markets to reach fresh highs.

Markets everywhere are up in the first half of this year, following the sell-off in December: a 14% gain for the TSX, 17% for the S&P 500, 16% for the Euro Stoxx 50 and 10% for emerging markets, the firm said. U.S. and Canadian bonds have gained 6%.

While trade uncertainty hurt markets in May, there was a strong rebound last month. The question is where these gains are headed in the second half of 2019.

Even after the strong period from January to June, stocks are at “a decent distance below fair value,” RBC Global Asset Management’s Summer 2019 Global Investment Outlook said. The challenge for equities at this point is stalled earnings growth rather than valuations.

“Even though revenues have been accelerating, profits have been held back by profit margins declining from record levels,” the report said.

While a recession or tariff escalation would hurt stock prices, RBC said equities could deliver single-digit or even low double-digit gains if interest rates and inflation remain low.

At the end of December, Richardson GMP noted, the S&P 500 traded at a valuation below 15 times price to earnings. It’s closer to 19 times now, lowering return expectations.

The report said there are two ways the “magic combo” will end. While weak economic data has lifted bond prices and led central bankers to move away from rate hikes, equity markets have responded to the policy effects while ignoring the data. Eventually there will be a turning point and stocks will react to the economy.

“Bad economic news can be good for markets for a while, after which it becomes negative,” the Richardson GMP report said. “This can happen without notice and with no apparent trigger.”

If it does happen, stocks would give up their first half gains and bond yields would dip even lower, the report said.

The more positive scenario is that economic data improves, leading to a strong rally for equity markets given bond yields are so low.

Portfolio weighting

RBC said it has reduced its overweight allocation to equities by half a percentage point, “moving further along the path of de-risking our portfolios as the business cycle matures.”

In addition to trade uncertainty, the outlook report cited late-cycle signals including low unemployment and an inverted yield curve to “gauge that the risk of recession is higher,” justifying moves to reduce risk in portfolios.

The firm moved the proceeds from equities to cash rather than bonds due to fixed income valuation risk and low sovereign bond yields (Japan and Germany are in negative territory and U.S. bond yields are 100 basis points below their 2018 high).

“The threat to sovereign-bond prices stems from the potential for a significant increase in real interest rates,” the report said. “Our models assume that real interest rates will inevitably rise to their long-term average, acting as a headwind for bond prices that could lead to low or even negative total returns in fixed income for a very long period into the future.”

Growth and interest rate forecasts

RBC raised its expectations for global growth to 3.5% for 2019 and 2020. National Bank Financial (NBF), in its monthly economic report, forecasts global GDP growth of 3.3% this year and 3.5% in 2020.

For Canada, NBF’s forecast of 1.4% growth this year and 1.8% in 2020 is unchanged, as are U.S. growth expectations of 2.5% this year and 1.9% in 2020.

RBC forecasts growth of 1.25% for Canada this year and 1.5% in 2020, compared to U.S. growth of 2.5% this year and 2.0% in 2020.

NBF expects the Federal Reserve’s target rate to fall 50 basis points this year and remain unchanged in 2020. “Healthy U.S. GDP growth does not preclude interest rate cuts,” the report said, highlighting trade uncertainty and the potential for a pre-emptive cut.

The Bank of Canada will hold this year and raise its rate to 2% in 2020, the NBF report said.

RBC’s base case is scenario is for no changes to policy rates in major developed markets in the coming year.

Read the RBC GAM outlook here, Richardson GMP’s Market Ethos here, and National Bank Financial’s monitor here.