On Your Marks!
08 Oct 2018
Last week I reviewed the performance of equity markets during the third quarter, declaring that investors had reason to be satisfied given the wide range of things that could have undermined confidence. Equities are the narcissists within portfolios, hogging the attention of headline-writers with their extravagant daily movements. The FTSE 100 Index and (anachronistically) the Dow Jones Industrial Average are quoted faithfully in news bulletins, the pound usually gets some coverage, but bond yields are rarely given a second thought, and so today it’s time to redress the balance in favour of Fixed Income investments.
First a quick look back to the third quarter, when it proved well-nigh impossible to make a positive return investing in government bonds. For a start, as has been the case for several years, there wasn’t much yield (or “carry”) available, so any notable tick up in yields (or fall in capital values, to look at it another way) was going to more than wipe out the income accrued. This duly occurred in response to evidence of strong growth, particularly in the US, and the accompanying concerns about higher inflation, with investors in the US, UK, Europe and Japan all experiencing losses, even on a total return basis (including income). The tale was similar in Emerging Markets, thanks to a strong dollar and the stresses in several countries including Argentina, Venezuela and Turkey. It might come as a surprise to many that the one corner of the mainstream bond market to generate a positive return was High Yield Credit – the artist formerly known as the Junk Bond Market. This jungle is inhabited by some of the more precariously financed companies, many of which fail to turn a profit, but the clue to the bulk of returns is in the label “High Yield” – at least you get some “carry” here (the US High Yield Index currently sports a yield of 6.41%, against a little over 3% for super safe government bonds of a similar maturity). Furthermore, financially constrained companies have more chance of meeting their obligations in a strong economic environment, and that is exactly what we have in the US today.
FTSE 100 Weekly Winners
|Paddy Power Betfair||1.2%|
FTSE 100 Weekly Losers
|International Consolidated Airlines||-7.4%|
So what about the here and now? Last week bond investors suffered further losses as yields rose across the world. Once again this appears to have been in response to robust economic data, especially in the US, but there were also hawkish sounding comments from several members of the Federal Reserve. Interestingly, despite fears of a tighter US economy, it is real yields that are rising rather than inflation expectations, with the theory being that the Fed can raise rates higher without upsetting the apple cart. Even so, there will inevitably come a point where the economy does decelerate, and that is when Mr Marks will be hunting for bargains amongst the detritus of defaulting bonds.
For now, at least, the strong pace of corporate earnings growth is enough to offset the depressing effect on valuations of the higher discount rate; and the Equity Risk Premium starts from a relatively high level thanks to the depressed bond yields resulting from Quantitative Easing. Thus, for all the shrill warnings, we continue to believe that there is enough puff left in the market cycle for us not to have to take a hard defensive position yet. However, as we have noted before, a continued sharp rise in bond yields which is not accompanied by decent earnings growth would set portfolios up for the worst scenario in which both bonds and equities fall, the positive correlation between the two asset classes that has rarely been evident since the 1990s (which was generally a benign era of falling inflation expectations, so both asset classes provided positive returns). Like the Chairman of the Fed, we are keeping an eagle eye on inflation expectations, which are the prime candidate for reigniting volatility, as happened in February.
Year to Date Market Performance
* IPD Total Return to September 2018
FTSE 100 Index, Past 12 Months
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