Valuation of bonds has become distorted due to seemingly indiscriminately buying.
As the US moves inexorably into an era of higher interest rates and a reduction in the level of central bank provided liquidity, certain aspects of investment markets, which have prevailed for as long as many market participants can remember, are likely to reverse.
US ten-year interest rates are now above 3 per cent and in our view have further to go. The US is clearly ahead of all other major economies in its tightening cycle but it’s only a matter of time before other markets have to follow.
The era of ultra-low interest rates, and indeed the long period of falling inflation and falling bond yields, has gone on for so long that certain expectations have been baked into investors thinking as to how assets should behave. We’ve seen over the past year many of these are now reversing and we think there’s more to come.
The most recent equity market correction may have been caused by rises in the US long bond and inflation, but it led to a sustained move in equity volatility back to levels we would regard as a more normal range. Selling volatility had been a popular income generating trade in the era of low interest rates and that led to short term volatility well below levels that might be regarded as appropriate. We think this is just one of several aspects of markets that will change as we move to higher interest rates.
Also during the recent correction, leadership among the major sectors was little changed from the trends of recent months, with technology, cyclicals and so on leading, while consumer staples, utilities and other interest rate sensitive sectors lagging. This surprised some commentators who have assumed staples and utilities to be defensive, while in our view it’s likely to be another feature of markets where the prevailing trend is for rising rates and rising inflation.
There’s another seeming inconsistency in recent market moves. Strength in the dollar in recent years has been considered negative for oil and for world economic growth. Recently oil and the dollar have been simultaneously strong. However, we think this is consistent with a world of rising inflation and rising rates. While in recent years there has been a negative correlation between oil and the dollar, this has not always been the case.
There are further potential adjustments that markets need to make as interest rates move higher. The valuation of many fixed income asset classes has become distorted as a consequence of yield seeking investors buying, seemingly indiscriminately. We would expect certain emerging market bond yields and some high yield credit spreads to move higher in the future, as the income available from US treasuries becomes much more attractive. Indeed, there have already been some signs of problems for Argentina and others.
Like the move to higher volatility, the underperformance of bond proxies and the more sensible pricing of emerging market dollar debt all seem to us moves towards normality, reflecting the higher US interest rate environment. It can be seen as healthy so long as higher rates are a function of a strong economy and higher, but contained, inflation. There are, no doubt, other anomalies that will unwind as QE turns to QT. Front of mind are ultra-low credit spreads, particularly in Europe and indeed most areas of fixed income are likely to struggle to make positive returns against a rising rate backdrop. Selectivity will be key in fixed income, while in equity relying on the QE period as a guide to the future may not work as we’re entering a very different environment.
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