New article from Tatton Investment Management: Bond market sell-off surprise

8 October 2018

Having written only last week that Trump’s trade wars may prove a bizarrely supportive factor towards safely unwinding overvalued bond markets, I feel as if I provoked bond markets to prove me wrong. Amongst the other news stories, bond markets will have been hardly noticed by most and, so far, the bond sell‑off and resultant rise in yields has not been so dramatic that it would divert mainstream media attention from party conferences or potentially untruthful US supreme court candidates.
But, capital markets do notice these things; the very sudden 0.15% jump in the yields of US government bonds with 10 years to maturity (10yr Treasuries) did send shivers through them, because the last time we experienced a similar magnitude yield move equity markets corrected very sharply. However, thus far, the reaction of stock markets has been far more muted, with equity markets more flat than significantly down. The reason for this may be that this time the yield hike was triggered by unexpectedly strong US economic data (service sector performance and jobs growth) rather than a jump in inflation readings.
Yield on 10yr US government bonds over past 12 months; Source: Bloomberg
While there is little difference for bond markets between the two (i.e. expectations of future inflation increase, requiring higher yields to prevent bond holders from selling), equity investors may be less worried that central banks commit a policy error by hiking rates to prevent inflation from taking hold.  
To recap the developments of the past months: After a considerable upward surge in US economic growth that was largely fuelled by Trump’s fiscal stimulus from last year’s tax cuts, data over the summer had suggested that the upward momentum was waning. The looming trade conflict escalation with China put some additional slow down concerns on the horizon. And consequentially, bond and stock markets had recently begun to trade sideways. But the latest economic figures might suggest that slowing concerns are unwarranted.
US central bank head Jerome Powell appeared to support such views with statements during the week that the outlook for the economy is “remarkably positive” and mused that the ongoing expansion can continue “effectively indefinitely”. He did not voice concerns over the looming trade conflict with China and suggested that interest rates would need to continue to rise.
At the beginning of the year, such marked words would have sent the equity markets reeling, because the growth spurt had only just started in the US and the fear would have been that the central bank smothers the upturn with premature rate rises before it has really started to take hold.
Now that growth momentum appears more solidly entrenched than previously thought, such central bank policy error concerns may be less prevalent. This may be good news for the economy and company profits, but it is bad news for holders of bonds with still historically low yield levels. As demanded yields rise, the value of their lower yielding bonds falls.
Towards the end of the week, market commentators started to fret that rapidly rising yields could have negative side effects. This dampened sentiment, sent yields in the other direction and cause some losses for equities. Up to a point, equity declines make sense, given rising bond yields decrease the relative attractiveness of current dividend and corporate earnings levels. However, it will be interesting to observe whether this still marginal stock market reversal will actually trigger a larger scale US stock market correction, given valuations there are at odds with those elsewhere. If this occurred, sentiment would likely turn on US stocks, especially if investors underestimate future interest rates and yields. In that case, even continued growth wouldn’t indicate further upside in US stocks, and investors may turn to less highly valued (but also economically expanding) regions like Europe or Japan.
At this point, we are comfortable with our underweight to both long maturity bonds and US equities across portfolios and will be assessing further developments with particular interest.
In other news, currency markets signalled – with a strengthening of £-Sterling versus the US$ as well as the Euro€ – that Theresa May’s Tory party conference speech might have, after last year’s disaster, strengthened her mandate for a constructive Brexit deal with the EU,
Following popular demand from our readers, we have dedicated a full article to our Brexit expectations. We lay out why we firmly believe that the current scare mongering is squarely political tactics and that the initial Brexit outcome next March will be far less disruptive.
With Italy being the other most often cited worry spot, we also summarise our views on why we see it as unlikely that the country should cause another Eurozone crisis but rather will manage itself out of its current troubles in typical Italian style.
Given we see China as far more influential to the global economic and investment prospects of 2019 than Brexit and Italy, we also run an in-depth article by our head of investment, Jim Kean, who has just returned from a week-long research trip all across China. He lays out that we should not expect significant growth impulses from the ‘Middle Kingdom’ as it grapples with the double challenge of improving governance across its economy while at the same time mitigating the negative effects of Trump’s trade war campaign.
 

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