Moves in bond markets influencing equity markets

When stocks go up in value, bonds go down and vice versa.

Not always, but as a rule, stocks have done well when an economy is doing well.

Consumers tend to buy/consume more and the result is that companies receive higher earnings.

When economies are not doing so well investors crave the regular interest payments associated with bonds.

The correlation between bonds and equities is pretty predictable. However investors have sought the sanctuary of bonds more in response to geopolitical events than straightforward economic ones in recent months.

In the US rising government bond yields have sparked fears of a corporate bond bubble.

In fact US Treasury yields rose after Donald Trump’s victory in the US presidential election precisely because the now president elect has promised a programme of investment in infrastructure.

Jamie Forbes-Wilson, manager of the Axa Framlington Blue Chip Equity Income fund and co-manager of the Axa Distribution and Axa Lifetime Distribution funds, says since 10 July 2016, when the US Treasury bond reached a yield of 2.088 per cent, investor expectations about deflation have inflected, marking an end to a 35-year downward trend in inflation and interest rates.

He says: “This change in investor perception was reinforced by the unexpected outcome of the US Presidential election in November and the creation of a new phenomenon dubbed ‘Trumpflation’.

UK inflation

Priced into the equation for bonds in the UK is inflation.

On Tuesday (13 December) it was reported the biggest increase in clothing prices in six years helped to drive the UK's inflation rate up to 1.2 per cent in November, up from 0.9 per cent in October.

November's Consumer Prices Index (CPI) inflation rate was the highest since October 2014, when it stood at 1.3 per cent.

The Office for National Statistics (ONS) stated increases in the price of petrol were also responsible for the slightly higher than expected rise.

James Illsley, group European portfolio manager for the JP Morgan Asset Management European Equity group, says many expect inflation to continue rising as a weaker pound results in higher import costs.

Inflation, of course, erodes the interest on bonds because investors are locked into a fixed income.

How this current movement impacts on equities will depend on what equities an investor holds.

Mr Illsley explains: “Bond markets are weakening but yields are going up because fiscal policy is looser than previous expectations, both in the UK and globally.”

Speaking as this guide was published in mid-December, he points to a rise in bond yields prior to Mr Trump’s victory.

“In July they bottomed out at 1.4 per cent now they are 2.1 per cent. Five-year forward swap rates have risen from 2.9 per cent to 3.6 per cent.”

Mr Illsley says bond prices will continue to be influenced by the adoption of fiscal policies and the expectation of rising inflation.

He says: “Inflation has been priced in. What does that mean?  

“Well as bond yields fell, companies which have been considered as bond proxies tend to stay stable.”

But Mr Illsley says this behaviour has reversed. “Companies considered to be bond proxies such as mobiles, telecoms, utility and food producers are down 10 to 16 per cent, falling quite sharply.”

Instead as bonds face inflationary pressures more cyclical stocks are now seen as offering better value.

Companies including miners, banks and life insurers have benefitted from the bond proxies fall in favour.

Mr Illsley says: “Within a week between the beginning and middle of December banks were up 24 per cent in value. As you can imagine they are not a small part of our portfolio.”

Mr Illsley predicts that this reflationary trend will continue, giving these sectors further to run.

“Banks are cheap and they stand to benefit from the shape of the yield curve.”

Mr Forbes-Wilson agrees: “Investor positioning has begun to change and there has already been a sharp rotation out of ‘bond-like’ equities, such as consumer staples and utilities, into commodities, financials and real assets.

“As markets anticipate ‘growth’ becoming more widely available, those companies that have been so highly-prized and afforded high price to earnings multiples in a low growth world have been sold down and ‘value’ stocks have climbed.”

John Husselbee head of multi-asset at Liontrust, says if government bond yields continue to rise this will have a negative knock-on effects on many other asset classes, “all of which are ultimately to some degree priced at a premium to this risk-free rate”.

He says: “Even though their valuations look elevated, we are reluctantly tilted towards risk assets including equities and we are making use of managers with distinct and robust investment processes – who will, for example, be investing in companies resilient to inflationary pressures –  and those that make use of innovative strategies – such as enhancing income through writing covered call options.”

End of bull market for bonds

Anthony Dalwood, chief executive of Gresham House, says bond yields have been the driver of all asset valuations.

He predicts the end of the 30-year bull market in bonds.

He adds:  “The current situation is rightly beginning to reflect the inflationary pressures that do actually exist in the developed world.

“The end of the bond proxy and quality/momentum investment bubble of the last five years is close.”

Patrick Connolly, a certified financial planner at Chase de Vere, says despite a recent sell off, many fixed interest assets are still looking expensive and corresponding yields are at low levels.

He says this is changing their role in many investment portfolios.

He says: “Those who are looking to generate a higher level of natural income have looked at whether to move up the risk scale and hold a higher weighting in equities to achieve this.

“In particular bond proxies, companies such as utilities and consumer staples, which offer stable growth, low volatility and steady dividends, have been very popular to the extent that many of these may also now seem expensive.”

Spectre of inflation

Chris Kinder, fund manager of the Threadneedle UK fund, says the spectre of rising inflation and the sense that monetary policy has maxed out has led the markets to believe that the next spur to growth must now come from increased government spending.

He says this has led markets to the conclusion that government fiscal positions will actually now deteriorate from here.

Mr Kinder says: “This view has rocked the global sovereign bond market and been supportive to equity markets (and inflation proxies) whilst undermining so-called ‘bond proxies’ in the equity market.

“From a UK perspective this impact was particularly notable as these ‘bond proxy’ companies had performed particularly well in the post-Brexit flight to ‘safety’ and ‘dollar earners’.

“We would argue that there are companies that have been swept up in this trade which are differentiated by the fact that they offer defensive, reliable growth and can deliver steadily growing dividends funded by underlying cash flow and appropriate levels of debt.”

Mr Husselbee sees all of this as an opportunity for investors.

He says: “De-synchronisation and greater heterogeneity means an opportunity for active managers to add alpha through their ability to research and differentiate between investments.

“The days of making straight risk-on or risk-off trades may be behind us as we see less intra-asset and inter-asset correlations.

“We have already seen sector rotation away from defensives (whose bond proxy characteristics drove share price higher but now represent a millstone around their necks) towards cyclicals, and the next step will be to observe greater differentiation at the security level.”