The New Year has kicked off with a burst of market volatility centred on bonds rather than equities. 10-year government bond yields jumped 0.2-0.3% last week to 1.8% in the US and 1.2% in the UK. Treasury yields are now slightly above their peak last March while gilt yields are back up to their October high.
The bond sell-off not surprisingly has sent the Santa equity rally into reverse. Global equities ended the week down 2% from the new high they made last Tuesday and are down further today.
The turmoil in bonds has caused marked moves in equities beneath the surface, most notably a renewed rotation out of expensive growth stocks into cheaper value stocks. The cheap UK market saw a gain of 1.4% over the week whereas the very expensive US market was down 2.4%. At a sector level, technology (the archetypal growth sector) lost 5% whereas financials (the epitome of value) gained 3%.
So why the marked rise in bond yields? The answer lies with the Fed. The minutes from their December meeting talked of potentially starting to run down their bond holdings (rather than just bringing new purchases to an end by March under the taper program) relatively soon after the first rate rise and at a faster pace than in the previous cycle.
The December US labour market numbers released on Friday did nothing to ease such concerns. Nonfarm payrolls saw a gain of only 199k, half that expected. However, the focus was on the unemployment rate which unexpectedly fell from 4.2% to 3.9%, suggesting the economy is now close to full employment. Wage growth also surprised on the upside. All this leaves lift-off for rates looking increasingly likely to occur as soon as March.
We expect US bond yields to continue to trend higher. They still look too low with Fed purchases set to go into reverse and US rates likely to peak at 2.5% or higher, rather than below 2% as currently priced in by the markets. Even so, a good part of the sell-off is probably now behind us and the path higher is likely to be an erratic one. It shouldn’t be forgotten that yields rose sharply last spring, only then to unwind most of the increase over the summer.
Rising bond yields will be a drag on equity markets but should not present a major problem. Equities sold off last week because of the abruptness of the rise in yields, as opposed to them reaching a level where equities no longer look reasonable value against bonds. We don’t see rising yields becoming a significant problem for equities until they have risen another 0.5% or so.
All the same, with valuations likely to be coming under downward pressure if anything, equities will only be able to see further gains if they are driven by corporate earnings. The Q4 reporting season kicks off in the US at the end of the week and the forecast is for a strong gain of 22% compared with a year earlier. As in recent quarters, earnings are likely to come in ahead of expectations.
However, markets are forward-looking and earnings growth is set to slow significantly over coming quarters and will clearly depend on the strength of the economy. Omicron is a key factor here and the latest news on this front is encouraging. Infections are down substantially from their peak in South Africa and also seem to have peaked in London, the other epicentre of the latest wave. It is also increasingly clear that Omicron infections are in most cases considerably less severe than for Delta.
Omicron looks unlikely to impose a significant drag on economic activity beyond the first quarter. This in turn should allow earnings to record high single digit growth over the coming year and provide the driving force for further moderate increases in equities, led by the cheaper markets. Still, such gains will very likely be accompanied by increased volatility now the authorities are starting to take away the punch bowl which has helped drive such a rapid rebound in markets.
Chief Investment Officer