Bond prices continue to defy gravity
Over the past week, yields on 10-year US Treasuries reached their lowest level for a year, while the S&P 500 reached a new all-time high. A similar trend is seen across the global developed markets, but it begs the question whether equity investors are too sanguine or bond investors too pessimistic.
Neither bond nor equity markets, in general, are cheap. But we believe bonds are clearly the more expensive asset class and the most susceptible to a correction of their gravity-defying trend. Our view that a gradual improvement in the global economic outlook will continue suggests little upside for low-yielding government bonds, with risks skewed toward a rise in yields by year-end.
To be sure there are more negative than positive risks around the continued gradual improvement in growth that we think is the most likely outcome for the global economy and markets this year. On the negative side, you have the Ukraine crisis, concerns about China’s banking system and slowing growth, the possibility that interest rates might be increased prematurely in the US or that expected easing may not materialise in the eurozone. Potential positive surprises are limited by comparison – more aggressive easing than expected in the eurozone and/or stronger growth and earnings than expected in the major economies.
Still, bond yields are so low (prices high) that it would take a fairly dramatic deterioration in the global economic outlook to push them substantially lower. For bondholders, yields are also near or below inflation, providing little real (inflation-adjusted) income.
Equities on the other hand are generally around what we would consider to be fair value on a longer-term basis. Not cheap but not expensive either, and attractively valued relative to bonds. Yields on 10-year Treasuries have dipped below 2.5% for the first time in a year, but we see them rising to around 3% (prices falling) by year-end amid a continued economic recovery.
Equities – Japan equities shrug off sales tax rise
Japan’s 1 April consumption tax hike was the first in 17 years, but we think fears of a market fall-out like the one that followed the 1997 increase are unfounded. That last rise took place against a banking sector that was near-insolvent and just ahead of the Asia economic crisis – neither is the case now.
So far in 2014, the market has tracked the same path as in 1997 (see chart overleaf, representing three key sectors that account for 26% of the TOPIX index), with the three sectors gaining 7% on average since the end of March and the retail sector leading at +5%. But we don’t expect consumption to falter as it did in 1997, and see Japanese equities trading in line with generally modest gains in global equities this year.
Bonds – hint of divergence between US and UK
Messages from the US and UK last week revealed a potential divergence in interest rate policy. While the Federal Reserve (Fed) minutes revealed no new information, New York Fed president William Dudley later in the week offered three reasons to keep longer-term rates below historical averages: i) lingering effects of the financial crisis, including higher precautionary savings and less investment; ii) demographics – slower growth of the labour force due to the ageing population and moderate productivity growth; iii) regulations requiring banks to maintain higher capital requirements.
Meanwhile, the latest Bank of England minutes were slightly more hawkish. Some members believe that the “monetary policy decision was becoming more balanced”, indicating they stand ready to vote for an earlier-than expected rate rise. With the 10-year gilt yield at 2.6%, we don’t believe it is pricing in the current pace of the recovery. We think improving growth and a tight labour market will push yields higher this year.