While bonds are still expensive, they can no longer be ignored as they are starting to influence equity markets, writes Liontrust’s Phil Milburn.
In the developed world, government bond markets have suffered from a decade of “financial repression,” meaning the income you receive has not kept up with the rate of inflation. In the autumn of 2018, markets for riskier financial instruments such as equities noticed there was a great big elephant in the room: the bond market.
Since the financial collapse and subsequent monetary policy response, government bond yields had been low enough for any increase to be interpreted as vindication of the strength in the economic recovery. But US Treasury yields have reached the stage where increases have a meaningful impact on the generic price of risk. Attention has switched to the monetary cycle and whether the Federal Open Market Committee will overshoot on its tightening.
Risk from rising rates and bond yields
The risks here for all investors are twofold. First, if the US Federal Reserve does raise interest rates too far, then a recession will inevitably follow a couple of quarters later. Secondly, the bond market is the prop that supports so many other more exciting asset classes. Low bond yields, coupled with a tsunami of central bank moneyprinting, have forced investors into riskier assets to enhance returns. As bond yields rise, the relative attractiveness of alternative investments must, by definition, fall.
For me, the most important factor for making inflation spiral upwards is rising wages. Examining the chart below, the shaded area shows the US unemployment rate, which doubled during the crisis but is now under 4%.
Many commentators have been surprised at the lack of wage inflation. The explanation that resonates most with me is the non-linear Phillips Curve. Historically, this theory posits that inflation and unemployment have a stable and inverse relationship. The inverse bit is obvious: as supply of labour falls, wages should rise. It is the stable (or linear) relationship that I question. I suggest that there is little wage pressure until we approach full employment, and after that salary inflation starts to accelerate. The clearly discernible upward trend in wage inflation is shown in the graph; if it breaches 3.5%, expect the Fed to tighten further.
Reappraisal of valuations looms
Meanwhile, it is definitely worth keeping a watchful eye on the gradual unwinding of the money-printing the Fed undertook. Its balance sheet has already shrunk by over $400 billion, and although there is less focus on this than on interest rates, it is a powerful driver of monetary conditions in the US and in any economy that actively uses the US dollar.
The European Central Bank (ECB) finished expanding its quantitative easing programme in December 2018. This year we certainly should be looking forward to rate hikes in Europe. I think ECB president Mario Draghi will want to raise rates at least once before his term finishes in the autumn. His central banking career epitaph could then read along the lines of: “Solved the euro crisis, boosted growth and started the path toward normalisation,” rather than: “Was a permanent dove bailing out the periphery”. So be prepared: just as the rising tide of loose money aided all asset classes, the retrenchment will lead to a re-appraisal of valuations.
I am a traditionalist, so I believe you should be paid a real rate of return for lending money to the government. I have a strong preference for US government bonds due to their more compelling valuations; the opposite applies for German bunds, and UK gilts retain pariah status in my eyes. Bond markets can no longer be ignored: they are still expensive, but are starting to influence equity movements. In this environment the one certainty is that volatility will increase – but with volatility comes opportunity. I am glad I have more than enough grey hairs to remember a few cycles. I may have put on a few pounds over the years, but this elephant does not forget!
Phil Milburn is co-manager of the Liontrust Strategic Bond fund.