The weather in March is known for its harshness and unpredictability, captured by the proverb: ‘In like a lion and out like a lamb.’ After nine months of strong equity market performance, bond yields surged last week leading to a spike in market volatility with consequences for both bonds and growth focused equities. The surge in bond yields reminded investors of the so-called ‘taper tantrum’ of 2013 when the US Federal Reserve talked about reducing Quantitative Easing, only this time there was no talk of a taper to the bond purchase programme.
Bond Yields Surge
The yield on both 10-year and 30-year US Treasury bonds notched up their largest monthly increases since 2016, moving from under 1% to over 1.5% in less than two months. Since the price of bonds moves inversely with changes in yield, this resulted in a significant fall in the capital value of high quality sovereign and corporate bonds.
The knock-on effect was a fall in the value of technology and other growth orientated equities, as well as utilities and consumer discretionary stocks. This is because the present value of future earnings for such businesses is less valuable if interest rates are expected to be higher in future. Although it is important to note that the NASDAQ market still finished up by nearly 1% in February despite the sell-off in the last week of the month, which some commentators regarded as a correction for the market having been overbought towards the end of 2020.
What Has Caused Bond Yields to Rise
Global Recovery, Inflation and Economic Stimulus
The simplest reason is rising inflation expectations as a consequence of an expectation of a global economic recovery as the world emerges from the coronavirus pandemic. This is driven by the effectiveness of lockdown restrictions bringing the disease under control and the rollout of vaccination programmes. In addition, the huge amount of economic stimulus and accommodative monetary policy is potentially inflationary, most recently the US $1.9 trillion Covid Relief recovery package.
This has led to the concern that inflation in the US could hit 3% this year, particularly if pent-up savings held by consumers are spent once lockdown restrictions are eased. This means that the break-even point with inflation-protected bonds could rise above the Federal Reserve’s annual target of 2%. Commodities and oil prices have also been increasing in recent weeks, a sign of increasing economic confidence.
Such inflationary pressure makes it more likely that interest rates will need to rise to keep a lid on inflation and avoid the economy overheating. So far, the Fed and the US Treasury have discounted fears of inflation with Fed Chairman, Jerome Powell characterising inflation as ‘soft’ and therefore no need for the Fed to change course, particularly with weak employment data. Janet Yellen, US Treasury Secretary has confirmed this dovish approach urging America to ‘act big’ to revive its economy, resulting in the enormous Covid Relief bill.
Once the selling of bonds gathered pace last week on the news of higher bond yields, technical factors exacerbated the market volatility. Selling caused more selling as investors panicked to close out loss making positions. In particular, mortgage-backed debt holders are particularly exposed to sudden moves in longer-term interest rates and their actions exaggerated the movement in yields.
This week has started with a rally in global equities as bond markets have steadied following the wild swings at the end of February. The 10-year US Treasury yield has settled back to under 1.45%, a significant reduction from its peak just above 1.6% last week. This strengthening in bonds was partly a result of Australia’s central bank purchasing $3 bn long-term bonds.
Further volatility cannot be ruled out in March as the global economy emerges from the pandemic. On the one hand, investors should welcome some signs of inflation, as it is evidence that economic activity is picking up, however, historical evidence suggests that inflation needs to be controlled at less than 3% for equities to make progress and maintain pricing power. Central banks will certainly be tested in terms of their agility, so as to maintain stability, confidence and ensure interest rates and other stimulus measure are supportive, but do not lead to an overheating in the economy later in the year.
Both the US Federal Reserve and European Central Bank are said to be watching bond markets carefully to monitor stability. Many commentators expect that central banks could step in and buy more long-dated bonds to contain the increase in bond yields and maintain stability. However, some ‘normalisation’ of interest rates with a gentle increase in yields should be welcomed over time. This process should help to avoid equity market bubbles and prolong the bull market as economic activity revives and artificial stimulus can be withdrawn.
So as to navigate these potentially choppy markets, equities are preferred over bonds, as Warren Buffett the famous US investor told his clients last week, ‘bonds are not the place to be these days’. Negative yields on many high quality bonds mean there is a danger in being recklessly cautious, locking in guaranteed capital losses over time. This can be mitigated by holding short-dated bonds or higher yielding bonds, subject to careful consideration of the issuer’s credit rating. Index-linked and convertible bonds can potentially provide useful diversification for bond investors.
In terms of equities, sectors such as mining, oil and financials should provide better protection against rising inflation than lower yielding growth companies. The US economy should rebound with Buffett declaring ‘never bet against America’, as the vaccination programme is rolled out and President Biden’s stimulus measures take effect. Northern Asian economies continue to offer attractive growth prospects and closer to home, the success of the UK vaccination programme and the recent Brexit trade agreement presents some interesting opportunities with reasonable valuations. Finally, many technology companies, particularly those engaged in clean energy and the digital economy have excellent prospects and should reward investors over the coming years.
Please note, our view of markets does not constitute investment advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise. Overseas investments are affected by currency movements and exchange rates. If you would like investment advice on your individual circumstances, please do not hesitate to get in touch, telephone 01392 875500, info@SeabrookClark.co.uk