Not entirely normal


The yield on US equities almost mirrors the yield on US Treasury bonds. That’s not usual, notes Richard Buxton, head of UK equities and manager of the Old Mutual UK Alpha Fund.

At the time of writing, the yield on the 10-year US government bond (at just over 2%) almost matches that of the 2% yield on the S&P 500 index.

Seasoned market watchers will know that, historically, equities have demanded a higher yield premium, due to the greater risks involved. They will also know that this reversed for decades, with equities yielding less than bonds before the more recent switch back to lower yields for bonds – driven by a combination of central bank buying and deflationary fears.

So right now we are close to equilibrium again. And you could argue the case for both equities and bonds, in equal measure.

Global stock markets, many nearing their all-time highs, are reflective of the constructive environment for the asset class, in light of recent healthy profits growth. Cue improving European confidence surveys and tightening labour markets for starters.

But the defence of bond bulls is, arguably, equally robust, highlighting, as it does, the sharp lowering in inflation expectations, softer US data, and the fading of the Trump trade.

Meanwhile, the Fed’s third rate rise in six months has taken short rates to 1%, a move which, as it happens, has contributed to a flattening yield curve.

While Janet Yellen clings rigidly to her dot plot, anticipating further interest rate rises in the months to come, it appears investors in the bond market have roundly concluded, ‘we don’t believe you.’

The truth of the matter is Yellen is prepared to look through the recent softening in inflation figures and, instead, focus on tightening in the labour markets, so signalling her intention that balance sheet normalisation could come ‘relatively soon’.

It won’t be lost on investors that, should she decide to act in the autumn, she will have chosen one of the most traditionally volatile periods in the investment calendar.

And yet, the second largest inflow of money into equity ETFs in the last 30 weeks is testimony to the fact that the ‘buy the dip’ mentality is alive and well, with investors looking for any opportunity to pick-up stock.

As Wall Street grinds ever higher, global markets carry all the hallmarks of being momentum-driven. The stock market is going up because it’s going up… a dangerous premise by any fundamental investor’s standards.

In the past, tech and media companies were deemed cyclical and volatile. But in today’s world of new dominant global leaders the FANG (Facebook, Amazon, Netflix and Google) stocks are exhibiting all the low volatility characteristics of consumer staples – and the steady and stable Unilever’s and British American Tobacco’s of this world – are marching in lockstep with them.

And, by the way, does anyone remember the old adage, following successive interest rate rises, ‘three steps and a stumble?’ It is after the third interest rate rise that equity markets can begin to feel the pinch.

One could characterise the multi-year rush into bonds, equities, property, bitcoin, and practically anything else you care to mention, as simply the biggest bear market in cash.

The incessant rolling of the central bank printing presses, which in the case of the ECB will continue to roll for some time longer, has resulted in cash being continuously devalued against other assets.

At what level of interest rates, I wonder, does cash become attractive again to investors?

Whichever month Yellen decides to act on balance sheet normalisation, it would appear she is no longer a lone voice in the wilderness, especially given the dissension in the ranks of the members of the Bank of England monetary policy committee. Investors may remember that, for some time now, I have been banging the drum for UK interest rates to rise more in line with their US counterparts.

Interest rates aside, there is one thing of which I am certain – with bond yields at these levels, the stretch between bonds and equities is unsustainable.

And, if that turns out to be the case, investors who have gorged themselves at the central bank table for far too long, reaping the rewards of cheap money to flatter corporate profitability, may well start to suffer a bout of indigestion.



FUND MANAGER

Richard Buxton

Richard joined Old Mutual as Head of UK Equities in June 2013. He was previously Head of UK Equities at Schroders, where he managed the Schroders UK Alpha Plus Fund for over 10 years...

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