Bonding with Equities

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Global equities slipped back last week, retreating 1.5% in sterling terms, and have also opened lower this morning. These declines, however, follow two weeks of strong gains and are nothing noteworthy.

Of rather more note, last Friday was exactly one year on from when equity markets hit their pre-Covid high. Remarkably, global equities are now up 10.5% in sterling terms since then. China is the stand-out winner with a gain of 36.2% while the US is up 12.1% and the UK trails behind with a loss of 6.7%.

But it was government bonds which were the main focus of attention last week. 10-year yields rose 0.15%- 0.20% in the UK and US to 0.73% and 1.38% respectively, and are now up some 0.4%-0.5% since the start of the year. Gilts have now lost 5.9% year-to-date, highlighting that UK government bonds are no longer the risk-free investment they once were – which is why we only have a small allocation in our portfolios.

The rise in the US has been driven by the prospect of another large fiscal stimulus over coming weeks. John Doe could well receive another $1400 cheque from the US Treasury, hard on the heels of the $600 they received only a few weeks ago. The latter incidentally was no doubt behind the unexpected 5.3% surge in retail sales in January.

In the UK, the January retail sales numbers also contained a big surprise – but of the negative variety. They plunged 8.2% as the lockdown took its toll. Moreover, no big give-aways are likely in the forthcoming Budget with any largesse limited to a grudging extension of the furlough scheme for a little while longer.

Instead, the spike higher in UK yields has been driven by the rapid vaccine roll-out and an end to speculation that rates could be pushed into negative territory. For all the talk from the Government at the moment of being driven by ‘data rather than dates’ and of only a cautious exit from lockdown, the markets are pencilling in a rapid rebound in the economy starting in the second quarter.

The current high level of equity valuations has been justified by the exceptionally low level of interest rates. The upward trend in bond yields naturally therefore raises the question of whether this increase poses a threat to equity markets. While far from complacent on this front, our view is that yields will have to increase significantly further than is likely before they pose much of a threat.

The rise in yields is being driven primarily by expectations of stronger growth and inflation, which are good news for corporate earnings and supportive for equities. It would be more problematic if it was down to worries that central banks were poised to start unwinding the massive monetary stimulus. But, as Fed Chair Powell will no doubt reiterate in his testimony to Congress this week, the Fed plans to remain ‘patiently accommodative’ to support the struggling labour market.

With no reduction in stimulus likely this year anywhere (possibly other than China), any further rise in yields should be limited. Back in 2013, in the so-called taper tantrum, US bond yields surged 1% in a matter of months on fears the Fed would start scaling back its QE. But even then, this caused no more than a brief correction and failed to halt the upward march of equities.

While bonds were the main focus last week, the pound did its best to grab the attention of UK investors, if not non-existent UK holiday makers. It hit $1.40 for the first time in just under three years, up from a low of $1.15 last spring, buoyed by the same factors driving up gilt yields.

Sterling’s gains, however, have been much more pronounced against a weak dollar than other currencies. Overall, the pound is only back to the top end of the trading range seen since its post-Brexit referendum slide in 2016. If as we expect, foreign investors start to appreciate the cheapness of UK equities, such inflows could drive the pound somewhat higher – hopefully in time for a resumption of foreign holidays later this year!

Rupert Thompson

Chief Investment Officer