Bond Mad

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There was only one real focus for UK, or should I say English, investors last week and I will do my best to avoid any mention of it. That said, bonds did their very best to compete for attention, with 10-year US Treasury yields falling as much as 0.20% by mid-week. They subsequently recovered a little to 1.35% but remain some 0.40% below their end-March peak and have now unwound around half their rise in the first quarter.

So why this big decline in yields which has caught many investors and commentators on the hop? As usual, when markets don’t go their way, strategists have come up with numerous weird and wonderful ‘technical’ factors to explain the fall. But these only seem to go so far to explain the decline and fundamentals also have some role to play.

The move by the Fed in late June effectively to bring forward the lift-off date for interest rates from 2024 to 2023 has been one factor driving longer-dated bond yields lower. It reduced the risk that the Fed would get behind the curve, to use a bit of market jargon, and would fail to raise rates early enough to prevent a major sustained rise in inflation.

The economic data have also recently come in a bit weaker than expected, with business confidence falling back from very high levels. There is also some nervousness that the surge in the delta variant across the Western economies will hamper the recovery, even if the vaccination roll-out has severely weakened the link to hospitalisations and deaths. Indeed, while the UK government is going ahead with ‘Freedom Day’ on 19 July, it has in the last couple of days become a little less gung-ho on the subject.

Markets do sometimes just get it wrong; most likely, just as bond yields overshot on the upside earlier in the year, they have now overshot on the downside. We believe yields will head back up again over coming months, with growth and inflation both set to remain high and the Fed likely to announce the start of QE tapering early next year.

So where does this leave equities? Well, they were little moved last week by the gyrations in fixed income, ending down a modest 0.2% in local currency terms. This makes sense. Lower bond yields are supportive of the high valuations of equities, so that is good news. But on the other hand, if the fall in yields indicates a weaker economic rebound, this means slower corporate earnings growth. So, a shrug of the shoulders overall seems apposite.

Lower bond yields have had a considerably larger impact on trends below the surface, rather than at the overall market level. They have been a major reason why the rotation seen earlier in the year towards cheaper value stocks away from expensive growth stocks has gone into reverse. Technology, the archetypal growth sector, has been outperforming again, whereas financials, which epitomise value, have been underperforming.

If yields head higher again as we expect, the rotation to value should resume. We are taking the opportunity provided by the recent move to reduce our exposure to growth stocks.

Last week saw a few other noteworthy developments. First, the ECB announced it is moving to a 2% symmetric inflation target, having previously targeted ‘below but close to 2%’ inflation. While this now allows for some modest inflation overshoot, this is a smaller shift in policy than the adoption by the Fed last year of average inflation targeting. Indeed, there are no immediate policy consequences of the move.

Second, the OPEC meeting saw a bust-up between the UAE and Saudi Arabia and no agreement on increasing production over coming months. The Brent oil price ended the week down close to 3% at $74/bbl on worries that this could herald unruly increases in output led by the UAE.

Finally, UK GDP disappointed in May, rising only 0.8%. Activity remained 3.1% below its pre-pandemic peak and is now unlikely to regain this level before the fourth quarter, particularly now July looks set to be rather less celebratory. This coming week is action-packed, with economic data and the start of the US Q2 reporting season, and hopefully should be a welcome distraction from yesterday’s events.

There was only one real focus for UK, or should I say English, investors last week and I will do my best to avoid any mention of it. That said, bonds did their very best to compete for attention, with 10-year US Treasury yields falling as much as 0.20% by mid-week. They subsequently recovered a little to 1.35% but remain some 0.40% below their end-March peak and have now unwound around half their rise in the first quarter.

So why this big decline in yields which has caught many investors and commentators on the hop? As usual, when markets don’t go their way, strategists have come up with numerous weird and wonderful ‘technical’ factors to explain the fall. But these only seem to go so far to explain the decline and fundamentals also have some role to play.

The move by the Fed in late June effectively to bring forward the lift-off date for interest rates from 2024 to 2023 has been one factor driving longer-dated bond yields lower. It reduced the risk that the Fed would get behind the curve, to use a bit of market jargon, and would fail to raise rates early enough to prevent a major sustained rise in inflation.

The economic data have also recently come in a bit weaker than expected, with business confidence falling back from very high levels. There is also some nervousness that the surge in the delta variant across the Western economies will hamper the recovery, even if the vaccination roll-out has severely weakened the link to hospitalisations and deaths. Indeed, while the UK government is going ahead with ‘Freedom Day’ on 19 July, it has in the last couple of days become a little less gung-ho on the subject.

Markets do sometimes just get it wrong; most likely, just as bond yields overshot on the upside earlier in the year, they have now overshot on the downside. We believe yields will head back up again over coming months, with growth and inflation both set to remain high and the Fed likely to announce the start of QE tapering early next year.

So where does this leave equities? Well, they were little moved last week by the gyrations in fixed income, ending down a modest 0.2% in local currency terms. This makes sense. Lower bond yields are supportive of the high valuations of equities, so that is good news. But on the other hand, if the fall in yields indicates a weaker economic rebound, this means slower corporate earnings growth. So, a shrug of the shoulders overall seems apposite.

Lower bond yields have had a considerably larger impact on trends below the surface, rather than at the overall market level. They have been a major reason why the rotation seen earlier in the year towards cheaper value stocks away from expensive growth stocks has gone into reverse. Technology, the archetypal growth sector, has been outperforming again, whereas financials, which epitomise value, have been underperforming.

If yields head higher again as we expect, the rotation to value should resume. We are taking the opportunity provided by the recent move to reduce our exposure to growth stocks.

Last week saw a few other noteworthy developments. First, the ECB announced it is moving to a 2% symmetric inflation target, having previously targeted ‘below but close to 2%’ inflation. While this now allows for some modest inflation overshoot, this is a smaller shift in policy than the adoption by the Fed last year of average inflation targeting. Indeed, there are no immediate policy consequences of the move.

Second, the OPEC meeting saw a bust-up between the UAE and Saudi Arabia and no agreement on increasing production over coming months. The Brent oil price ended the week down close to 3% at $74/bbl on worries that this could herald unruly increases in output led by the UAE.

Finally, UK GDP disappointed in May, rising only 0.8%. Activity remained 3.1% below its pre-pandemic peak and is now unlikely to regain this level before the fourth quarter, particularly now July looks set to be rather less celebratory. This coming week is action-packed, with economic data and the start of the US Q2 reporting season, and hopefully should be a welcome distraction from yesterday’s events.

Rupert Thompson

Chief Investment Officer