Bond yields have now risen a long way very quickly, and we would not be surprised by a short-term rally as economic data and risk appetite ebb and flow in the weeks ahead.
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As we write, the possibility of Western intervention in Syria is boosting demand for safe haven assets. However, in the context of our economic outlook, and our reading of the more subjective risks, we still feel that there is more durable upside than downside in 10-year yields (and of course in short-term rates) from here.
“Fair value” for yields is difficult to pin down, but the likely trend rate of growth in nominal GDP – that is, the sum of inflation and output growth – is as good a starting point as any. We estimate those prospective trend rates at 4-5% for the US and UK, and perhaps 3-4% for bunds. With current 10-year yields at 2.8%, 2.7% and 1.8% respectively, these core markets still look strategically expensive to us. 30-year yields – and UK War Loan – are closer to those suggested fair values, but are not immune from further cyclical weakness: yields can overshoot just as they’ve undershot in recent years.
In dedicated fixed income portfolios, we’d keep duration short, and continue to favour continental European benchmarks over Treasuries and gilts (the former include procyclical Italian and Spanish bonds alongside core markets). We’d also continue to scout out high-quality floating rate opportunities, although more as portfolio insurance than as a source of short-term yield.
In the context of balanced portfolios, we have a low strategic weighting for core government bonds to begin with, and our underweight tactical tilts focus on investment grade credit and emerging market bonds (which, together with speculative grade credit, forms the high yielding fixed income asset class). Our preferred fixed income segment remains speculative grade credit, but, even there, we would be no more than tactically neutral – at this stage of the cycle we worry not about default risk but underlying interest rate exposure. Such credit has relatively low duration, but history tells us that it can nonetheless suffer if core bonds sell off sharply enough.
Stocks are still inexpensive, even after their rally
We are currently recommending a little more cash than usual – not because we think that yields there will be meaningful any time soon, despite the upward creep in forward rates, but we see it as a source of funds for bargain hunting should markets be volatile in the weeks ahead. The cash has been raised from a tactical move to underweight in commodities in mid-July (discussed in more detail in Commodity fundamentals shift)
We continue to recommend a tactical overweight on developed equities. For us, monetary normalisation has long been the most visible pothole in the investment road ahead, and it could easily lead to the sort of setback that would be worth trying to avoid.
However, given the wider context outlined above, and our belief that prospective equity valuations, though no longer so obviously cheap, are still far from expensive, we have stuck with the call. Prospective price/earnings ratios are almost in line with 10-year averages (see Interest rates, bond yields, and commodity and equity prices in context) and, we think, plausibly so (see Is the rebound in corporate profits plausible?). Price/book ratios are still firmly below trend, and valuations that incorporate bond yields and profitability are lower still (although, of course, less so than last summer).
In absolute terms, annualised equity returns seem unlikely to be as robust as in the first two thirds of the year. But if prices just keep pace with likely earnings growth – that is, if PE ratios rise no further – stocks can make further absolute and risk-adjusted gains.
Our conviction remains greatest at the asset class level: regional and sectoral views are secondary. That said, we continue to favour both the US and continental European markets; we stay neutral on Japan, where a convincing conversion to capitalism still remains elusive, and are underweight the rest of developed Asia and the UK (though, in each case, we prefer local stocks to bonds). Sectorally, our preference remains for a mix of cyclical, technology and energy sectors ahead of staples, utilities and telecoms.
We remain firmly neutral on financials, with the exception of the US market where improved bank balance sheets, a recovering housing market, and earlier monetary normalisation continue to offer more visible opportunities.