Apologies for the radio silence last week – slightly bonkers week. Many thanks to those who attended the AltFi Digital Wealth Forum which was a great success.
The yield of ten-year US government bonds is often used as a totem for the future. The conventional wisdom is that as these ten year yields increase, the risk of a recession increases – thus increasing financial asset volatility. It isn’t, of course, a linear relationship. An increase of say 30 basis points from 2.3 to 2.6% is likely to have much less significance than a move from 3.3 to 3.6%. The conventional wisdom is that a push through 3% is a trigger for closer inspection, whilst a push past 3.5% is usually a sign of trouble ahead. A push past 4% usually tends to suggest that you should sell equities as quick as you can.
Obviously, we should treat these as rough and ready guidelines – the wider context matters. The current rate is 3.23% the last time I looked. I’ve spent much of the last year watching that 3% level like a hawk and we now seem to have decisively broken past that point. Again, we shouldn’t be completely surprised as bond yields are reacting to the steady increase in US interest rates – which is itself pushing up the dollar.
But the alarm bells are beginning to ring nevertheless. Matthew Bartolini, Head of SPDR Americas Research recently observed that the 10-year Treasury note yield has reached its highest level since 2011. Crucially the market is pricing in an 80% chance of another interest rate increase in December. The SPDR researcher has looked at the implications for ETF investors. His key findings are, I would suggest, slightly worrying:
- 9 of the 30 largest fixed income ETFs had losses in 100% of rolling one-month periods from December 31, 2012 to September 28, 2018
- 18 of the 30 ETFs had losses in 90% of the rolling one-month periods
- 24 out of 30 ETFs recorded losses in 75% or more of these periods
- Notably, losses weren’t confined to any particular fixed income category
Obviously, there’s a huge subset of questions surrounding fixed Income ETFs, but the more interesting debate has to focus on the broadest range of financial assets. A recent paper from the European Cross Asset research team at Morgan Stanley peers into the crystal ball and comes to some equally worrying conclusions. In a paper out this week, called Are Rising Rates a Problem? They largely come to the conclusion that …yes they are if rates carry on increasing. The caveat with this is that “Contrary to popular perception, rising rates are generally associated with higher equity markets, both being driven by greater optimism about the future growth backdrop.”
The bad news is that the current market environment is rather more challenging – specifically
1) Most of the rise has been driven by US 10-year real rates, which have broken the stable five-year range of 0-85bp. A wider band of uncertainty for rates is a cause for investor caution.
2) Low rates have underpinned equity multiples at high levels and a further rise in rates would push equity premiums from average to rich in the US.
3) Higher US real yields usually strengthen the dollar, which exacerbates the developing headwinds for US earnings.
So, what should investors do? Digging around in the paper there are a number of interesting conclusions for portfolio-based investors.
- The first rather obvious conclusion is that investors might start becoming more cautious about US equities. “Our US equity team has flagged 3.25% as the level of 10-year Treasury yields at which risk premiums will fall into over stretched territory. Other regions, particularly Europe, still enjoy above-average risk premiums”
- “USD strength is a headwind for earnings, which are already facing tougher YoY comps on tax-boosted earnings into 2019.”
- Buy value stocks, at long last! “ We think that global value stocks are due for a rally in the coming months as relative valuations are too low and earnings achievability looks better than that of growth stocks. The rise in real yields could just be an added catalyst to kick-start the rally for some investors, even though that hasn’t been the case in the past.”
- Gold might, after a long wait, be about to shine. “Real yields have historically been an important driver for gold – higher real yields usually mean that gold is lower. However, YTD declines and already extreme short positioning have helped gold to buck the longer-run relationship to real yields and stay resilient. We like to stay long gold despite rising real yields and recent dollar strength. Tentative signs of better physical demand, the approaching peak jewellery season in India and mine suspensions should also be a support for gold.”