One of the reasons why economic news can sound gloomier than it needs to is that the traditional employers of most financial talking heads are fixed income and money market departments.
There are important exceptions: corporate bonds are partly driven by issuers’ creditworthiness, so their prices go up less when the economy weakens because credit quality falls with it. The same is true of some government bonds, for similar reasons.
More importantly, when falling interest rates reflect lower inflation, or a secular reassessment of real borrowing costs, bond prices can rise – and yields fall – even as economies grow. We have seen this often during the 30-year bull market in bonds that followed the awful inflation – and sky-high interest rates – of the 1970s.
Performance of indices since 1986
Source: FE Analytics
Indeed, bonds have done such a good job of protecting and increasing wealth in this period that we suspect many private investors have come to view their bonds as trusted family retainers to be cherished to maturity rather than put out to grass.
Nonetheless, a stronger economy – and more job creation – is more likely to nudge bond yields higher, and prices lower. And this is what we think is driving the normalisation of interest rates that lies ahead, and why we welcome it.
The latest batch of data – even net of last week’s lagging US jobs report – suggests that economic activity has indeed picked up on both sides of the Atlantic, most visibly, and unusually, in the UK.
This is why bond prices were again falling, and forward interest rates rising; in the latter case, despite the misplaced efforts of the central bankers to guide them back down.
Performance of indices over 3months
Source: FE Analytics
US and UK 10-year bond yields have already doubled from last year’s lows, and have almost done so in Germany. But at $3, $3 and $2 respectively, they remain below the likely trends in nominal GDP growth and what we have long thought of as fair value.
Conversely, while developed stock prices have risen a long way, they continue to look inexpensive to us. Stocks’ fair value has little to do with cyclically adjusted P/E [price/earning] and [Tobin’s] Q ratios, which are even more flawed than conventional valuation metrics.
Not everyone shares our view about the US economy’s ability to shoulder the higher mortgage rates that recovery will bring, or about stock valuations, and markets may grow nervous again in the weeks ahead.
Meanwhile, as the G20 and the UN come to terms with events in Syria, bonds may appeal as safe havens for a while.
Some think that the German election on 22 September could have a similar market impact – though we doubt that. But looking beyond short-term volatility, we think portfolios should mostly be aligned with what is best for people and business.
We say mostly, because emerging markets could be hit by further portfolio outflows as western monetary conditions normalise.
Performance of indices over 2yrs
Source: FE Analytics
They are now cheaper, and some advocates have backtracked: much bad news is indeed in the price. Even so, emerging markets may remain vulnerable until developed yield curves have steepened still further.
Kevin Gardiner is chief investment officer for Europe at Barclays Wealth and Investment Management. The views expressed here are his own.
