Bond markets were once again the centre of attention last week, with government bond yields continuing their upward climb. 10-year yields in the UK and US rose another 0.10%-0.15% to end the week at 0.86% and 1.45% respectively. UK gilt yields have now risen 0.62% since the start of the year or, to put it in more sensationalist (but less meaningful) terms, they have more than tripled in the space of two months.
The turmoil in the bond market duly took its toll on equities with global markets retreating 3.0% over the week. Even so, equities remain up 2.4% in local currency terms year to date and the recent correction is really nothing to write home about, particularly as we’re all at home anyway.
The rise in yields has left bonds across the board nursing losses this year. But the extent of the hit has varied significantly depending on the type of bonds you hold. The UK gilts index has lost as much as 7.3%, making it all too clear why government bonds are no longer viewed quite the way they once were. As one wag put it, far from offering risk-free returns, government bonds now just offer return-free risks.
Corporate bonds, which form the bulk of our fixed income holdings, have fared rather better than government bonds. But the most important factor determining how well a bond has performed recently has been its maturity. The longer the maturity, the greater the fall in price for a given rise in yields. We have been wary of long maturity bonds for a while and our fixed income holdings have as a result generally held up well in the latest sell-off.
We expect bond yields to continue to trend higher but, crucially for equities, believe further increases will be considerably slower. A strong rebound in growth and a sharp but temporary pick-up in inflation, on the back of the rebound in oil prices, should continue to push yields higher.
However, the upward push will be resisted by central banks. Fed chair Powell in his testimony to Congress last week reinforced the message that the Fed is still a long way from raising rates and some way from scaling back its quantitative easing. It needs to see both a return to full employment and inflation move up to 2% and be on track to exceed 2% before it increases rates.
The market has brought forward its timing of the first rate hike to early 2023 and this seems the very earliest the Fed is likely to move. As for scaling back QE, no move on this front is expected before next year.
The bottom line is that we do not think bond yields will rise either quick enough or far enough to prevent equity markets from seeing further gains as earnings rebound on the back of a strong recovery later in the year. Indeed, the storm already shows signs of subsiding with bond yields falling back a little this morning and equities recovering.
Rising bond yields should have much more of an impact on which sectors and countries do best. As was seen last week, with the UK outperforming China and financial stocks outperforming tech stocks, they should lead to a further rotation out of last year’s winners into the cheaper and more cyclical areas which lagged badly last year.
Reams of time, if less so paper in this electronic age, have already been spent speculating on the contents of the UK budget on Wednesday. Judging by the confidence expressed in some of these predictions, the leaks seem well placed and there looks unlikely to be much to surprise us, aside from the odd snippet to keep us awake and the opposition on its toes.
So, in a bid to support the government’s moves to go green and boost productivity, I will keep my comment very short. Basically, Sunak looks set to extend most of the covid support measures for another few months while lockdown restrictions are being eased. As for tax rises, there will be warnings that they will need to rise significantly down the road to put the government’s finances back on a sustainable footing but any immediate move should be very limited.
We will distribute a review of the specific budget measures on Thursday morning and will address the more general market-wide implications in next Monday’s commentary.
Rupert Thompson
Chief Investment Officer