Government bond markets appear well and truly spooked this Halloween. Yields on US treasuries have surged in the past six weeks in reaction to concerns about Donald Trump’s potential return to the White House, US fiscal irresponsibility, the sceptre of rising inflation and geopolitical tension.
Equity markets, on the other hand, have been remarkably complacent but that could come back to haunt investors, according to Emma Moriarty, a portfolio manager at CG Asset Management.
Asset valuations are divorced from what’s happening in the real world
The valuations of equities and corporate bonds are starting to look unrealistic given the latent risks, Moriarty said. “Asset valuations have become way out of alignment with what is actually happening in the real economy. There does seem to be this de-linking going on,” she said. Valuations are “starting from a really inflated place”.
US equity valuations are the most obvious example of an expensive asset class but the same is true of corporate bonds. “We've now been in a situation where interest rates have been elevated for some time. We know that there's this wall of refinancing that has to happen in the US and the UK next year and yet, credit spreads are at historical lows at exactly this point when, actually, risk sentiment should be a little bit more elevated,” she explained.
The Bank of England’s Financial Policy Committee recently said that valuations across several asset classes, particularly equities, were “stretched” and “markets remain susceptible to a sharp correction”.
The question then becomes whether there is an imminent catalyst for a correction – and if the US election could be it.
“One thing we can say is that a Trump victory would crystallise this path of much wider fiscal deficits so that is probably a potential moment for a treasury market repricing,” Moriarty observed.
The impact of a Trump victory on equity markets is much harder to forecast, especially because Trump's policies are “not necessarily clear or consistent with each other”, she added.
Complacency has been building up
In a similar vein, Chris Metcalfe, chief investment officer of IBOSS Asset Management, said financial advisers and their clients are all focused on the potential upside from equity markets. While everyone is asking questions about further stock market gains to make sure they aren’t missing out, very few people are asking about downside risk, drawdowns or volatility, he said.
Complacency has been increasing because “equities have been going up so well for so long”, he observed.
It is not complacency per se that could spook investors but the disappointing returns it presages. “There is always complacency” just before market corrections, Metcalfe observed. “You don’t tend to get markets with a lot of fear [leading into] sell-offs”.
Nick Clay, manager of TM Redwheel Global Equity Income, thinks investors are pinning all their hopes on a soft landing in the US and are under-prepared for any other scenario. “What scares me is when markets are convinced that a particular outcome is a foregone conclusion, as this is invariably when risk is most elevated,” he said.
“Today, markets continue to push through all-time highs on the conviction that the Goldilocks outcome is a certainty that nothing can derail, impervious to geopolitical tensions, upcoming US elections or slowing growth in many areas.”
US equities could flatline in real terms
All this complacency is setting the scene for disappointment. Goldman Sachs reckons that the S&P 500 will return just 3% per annum over the next decade. After accounting for 2% inflation, fund managers’ fees and foreign exchange risk, those meagre gains could be eroded to almost nothing.
The investment bank’s forecasts are more pessimistic than its peers because it has factored in the extreme concentration of US equity markets. The S&P 500’s 10 largest stocks now amount to 36% of the benchmark. An extremely concentrated index reflects a less diversified set of risks so will probably be more volatile, said David Kostin, chief US equity strategist at Goldman Sachs.
Yield on 10-year treasuries could spike to 5%
Turn to the bond markets and everything looks much more frightening.
The yield on 10-year treasuries has surged by about 60 basis points since the US Federal Reserve cut interest rates by 50 basis points on 18 September.
Arif Husain, head of fixed income at T. Rowe Price, thinks the bond market sell-off could gather momentum and that the 10-year treasury yield could “test the 5% threshold in the next six months”.
Gael Fichan, head of fixed income at Bank Syz, said yields have risen due to “multiple forces at play: stronger-than-expected US macroeconomic data, commodity price inflation fuelled by Chinese stimulus measures, and recent statements by Fed policymakers advocating a higher terminal rate”. The increasing probability of a Republican ‘sweep’ (taking the presidency, Senate and House) is also fuelling market anxieties.
The MOVE index, a barometer for bond market volatility, hit a one-year high on 7 October 2024 – surpassing levels seen during the Silicon Valley Bank collapse and the Fed's 75-basis-point rate hike in June 2022.
“According to MOVE creator Harley Bassman, this marked the first time that one-month options extended beyond the election date, reflecting heightened political anxiety around future yields,” Fichan said.