Equity investors really need to keep an eye on US and UK bonds
Thursday 07 Oct 2021 Author: Ian Conway

For global investors who want to spread their risk by allocating money across different asset classes, the US 10-year Treasury bond is pretty much the first thing they buy.

To all intents and purposes, the yield on the 10-year T-bill, as it’s known, is the world’s risk-free rate, against which all investments are measured. That’s because the US has never defaulted on its debt.

In the space of a week, the US 10-year yield has risen sharply from 1.25% to 1.5%, which on the face of it doesn’t seem much but it means the cost of issuing new debt has risen by a fifth. It is also one of the quickest moves up in US Treasury yields the market has seen in a very long time.

Almost immediately, US stocks have begun to fall, but the question is why?

Furthermore, what does a rise in US – and UK – bond yields mean for equity investors? Read on to find the answers.

RISKS INCREASING

We said the 10-year yield was the world’s risk-free rate, which means other investments must yield a premium over this rate commensurate with the risks involved.

Equities are riskier than government bonds, so they must yield more. If the risk-free rate jumps as sharply as it has of late, there is a knee-jerk reaction by global investors to sell risk assets.

There are several reasons why US yields moved up so sharply. First, now that the US economy is back on track, the Federal Reserve has said it will buy fewer US bonds, which is how it has been injecting liquidity into markets.

If the Fed isn’t supporting bond prices to the same extent, prices will likely fall meaning yields will rise.

Second, US inflation is currently running at 5.3%, way above the Fed’s official 2% target. For all the arguments about inflation being ‘transitory’, it is taking its time in falling. If it remains stubbornly above the Fed’s target, the central bank will have no choice but to raise interest rates.

In the past, when the Fed has raised rates too soon it has choked off the recovery, as it did after the great financial crisis. How soon is too soon is the subject of great debate right now.

ARE RISING RATES BAD?

Rising interest rates aren’t necessarily a bad thing. For starters, investors with large amounts of cash savings have been getting little to no interest for several years and would be very happy to see rates rise.

Similarly, the banks would like to see rates rise as they have been mired in a low-rate environment where they have barely been able to eke out a margin between their loans and deposits. The higher rates go, the better for the banks.

Also, rising official interest rates are usually a sign that an economic recovery is complete and that businesses are healthy enough that they can bear a higher rate of interest on their debts.

However, if the economy hasn’t fully recovered and inflation remains high, we could be in a state known as ‘stagflation’, where costs are rising but growth slows, and unemployment rises because companies are trying to cut costs.

WHAT DOES IT MEAN FOR STOCKS?

If the spike in yields is temporary and there is no increase in official interest rates – which is certainly the party line in the UK and the US, although central banks in several other countries have already raised their benchmark rates – then stocks are likely to shrug off their worries and resume their upward trend.

What matters though are expectations, because stock prices are essentially driven by investors’ and companies’ hopes for the future, not the past.

Once investors begin to assume that inflation and interest rates will rise rather than fall, they start looking for stocks with higher returns. Those that pay little or no dividend – for example, stocks which are fast-growing and need to reinvest all the cash they generate to keep growing – start to look less attractive.

Typically, high-growth companies tend to trade at a premium to the market, so investors may move to take profits and recycle them into cheaper stocks, in particular those with a higher cash flow or dividend yield than the market.

Stocks which are considered risky – and which need to offer higher returns to make them attractive to investors – are also likely to see profit-taking as money flows into safer alternatives.

‘Long-duration’ stocks, which compound returns over a very long time – rather like a bond which compounds over 10 years – also tend to trade at a premium to the market, making them vulnerable to selling.

Therefore, we could see another phase of ‘value rotation’ in the market, where banks, raw materials, energy and other ‘cheap’ stocks start outperforming and ‘quality’ stocks including technology and growth companies underperform.


Winners and losers if the market predicts more inflation and rising interest rates

Banking stocks

Energy stocks

Mining stocks

Value stocks

 

Fast growth stocks offering little or no dividend

Fast growth stocks trading on a premium rating

Long duration stocks trading on a premium rating

High risk stocks

 

 

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