Bonds and stocks are supposed to be opposites in the balance of capital markets, with debt issues gaining value during stock sell-offs and vice versa. This fundamental principle of one asset class compensating for the other’s downward moves could falter if uncertainty rises enough to drive investors to cash at any cost.

That happened in 2008, when anything other than cash seemed hopeless. It could happen again. Indeed, big stock drops that trigger margin calls make sell-offs in every asset class a possibility.

The outlook for U.S. bond prices is negative. If President Donald Trump and the Republican majority in Congress achieve what they have promised, interest rates in the U.S. will rise as more government borrowing is used to finance infrastructure spending; as well, tax revenue will tumble as a result of aggressive tax cuts. More government spending is bullish for stocks and the greenback – and bad for Canada. If the U.S. demands significant changes in the North American Free Trade Agreement (NAFTA), Canadian stock prices would sink and interest rates would drop as business demand for loanable funds declines. Canadian balance sheets would be victims of a rush to risk reduction, lower leverage and lower expectations for stocks’ returns.

The Bank of Canada (BoC) might even be forced to use quantitative easing (QE) – that is, buying back sovereign bonds – which would push up bond prices and push down domestic interest rates. The loonie probably would wither relative to the greenback. The question thus becomes whether, with ever less support for Canadian equities, there could be a big sell-off and a resulting rush for cash, regardless of what the BoC may do.

“I think the [U.S. Federal Reserve Board] is on hold because [chairwoman Janet] Yellen is not aggressive,” says Chris Kresic, partner and head of fixed-income for Jarislowsky Fraser Ltd. in Toronto. “The anticipated hike in the Fed’s overnight rate for the first quarter, which did not happen when the Open Market Committee met Jan. 31 to Feb. 1, was a soft forecast. But the way the data is going, the Fed can wait until March or even June. It has a lot of room to hike rates. Canada’s outlook is weak.”

The data back up Kresic’s pessimistic outlook. Statistics Canada reports that the ratio of household debt to household income is at an all-time high, while residential construction makes up 35% of the annual increase in gross domestic product. The implication is that any disturbance in the economy or consumer spending could push Canada into recession.

Canadian consumers are tapped out. Business investment is not strong and the oilsands, it goes without saying, are struggling.

“Canada’s export markets are the last leg of the stool,” Kresic explains. And Trump threatens it with his plan to impair NAFTA.

The trend of interest rates in the U.S. should be upward. Liberty Street Economics, the research unit of the Federal Reserve Bank of New York, published a study in November 2016 that indicates the trend for the “natural” rate level for U.S. interest rates – with no interference from central banks – should be mildly positive and rising for the next few years. Of course, if the actions of the Trump government impoverish U.S. trading partners, U.S. exports might wither.

Should that happen, the perfect storm of reduced U.S. corporate earnings, a corporate bond sell-off, reduced Canadian corporate earnings and QE forcing down Canadian bond yields would manifest itself.

Political actions that raise risks, such as threats of war or potential imposition of tariffs that balkanize today’s integrated markets, such as the European Union, could have the combined effect of forcing stock and bond prices down simultaneously. That happened in 2008, when assets were sold off, both stocks and bonds, and highly leveraged homes in the U.S. were abandoned. There was a rush to liquidity and short-dated government debt. The idea that bonds and stocks typically move in opposite directions was shown to be wrong in that panic.

Much of the crisis of 2008 has been blamed on the collapse of the U.S. mortgage derivative market and the crumbling of its credit pyramids. Those issues have been tamed, at least for now, and banks have reduced their mortgage risks.

What there could be instead would be a rush to liquidity, driven by fear. For the U.S., that could be a threat of war. Skirmishes with China or an expansion of the war in Ukraine or a move by Russia to take back the Baltic States could shock markets and stimulate a rush to cash at the expense of other asset classes.

Says Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto: “If stock markets perceive more risk ahead or faltering corporate earnings, and bond markets decline because of more Treasury bond issuance in the U.S. to cover a growing debt – a process called ‘disintermediation’ – then both stocks and bonds would head down.”

Adds Jong: “The combination of sinking stocks and illiquidity in debt markets, topped out by consumers borrowed to the max, could reproduce the [scenario] of 2008. The crisis would hit the illiquid private mortgage and loan market hardest, where people would rush to sell at any price. But it could spread if investors get margin calls.”

Provided no major bank collapses, it would be a mild crisis. But if companies have to sell assets to repair crumbing balance sheets and if investors have to meet margin calls when stock prices collapse, then cash would be king again and the crisis of 2008 could seem quaint.

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