Traditionally, when bond yields rise equity markets fall as investors take advantage of higher returns for less risk. And in the last few weeks, we’ve seen just that. US interest rates increased, bond yields followed suit and equity markets became agitated. This made way for the biggest market correction we’ve seen since February.
The Federal Reserve stated that there could be several interest-rate rises in 2019, and that this higher-rate environment could be with us for the long-term. These increases in interest rates have been driven by economic growth, rather than inflation, and they are not at levels to threaten company earnings—yet. The equity market however is forwards looking, and investors are starting to question how corporate earnings will hold up when interest rates are no longer stimulative.
US economic growth pulls bond yields higher
Bond yields tend to reflect the outlook for future economic growth. As you can see from Chart 1, growth can be seen to be pulling US 10-year bond yields higher, and this looks set to continue.
Chart 2 shows these yields are now at their highest level since 2011, although they are still relatively low when compared with historic levels. We think yields of 4% are a reasonable expectation in the medium-term.
“The recent increase in bond yields is recognition that the US economy is strong enough to handle higher interest rates. After many years of low interest rates, markets have acclimatised, and the prospect of higher rates for longer has unsettled investors.” - Philip Smeaton, Chief Investment Officer
What does this mean for investors?
The Federal Reserve’s bullish commitment to raising interest rates shows they are willing to fight inflation at all costs. In the short-term, investors can continue to benefit from the booming US economy. Unfortunately economic booms do not persist indefinitely and portfolios should be built assuming that economic growth slows over the next few years.
Investment view: A glimmer of optimism for the UK
With all the doom and gloom surrounding the UK and Brexit, it’s refreshing to be able to report some positive domestic news. In previous months we’ve talked about manufacturing data, and in particular the Purchasing Managers’ Index (PMI), as a temperature check of the economy.
Manufacturing fares well
As you can see from Chart 3, the UK’s PMI score is above other G20 countries such as China and France, and on a par with Germany. This reflects improved optimism among UK manufacturers thanks to increased orders, inventory rebuild, increased employment and higher selling prices.
Low unemployment and wage growth (finally!)
Unemployment has fallen to 4%, meaning that most people in the UK who want a job have one. At the same time, wage growth is on the increase and is the strongest it has been for 10 years. All of this is good news for the UK economy. More money in pockets means there’s potential for improved consumer spending. And if interest rates do rise, people will be in a better position to cope with it.
Domestically focused UK businesses have been out of favour with investors, but there are still opportunities to be had. Indeed, as these companies appear ‘cheap’ relative to their US counterparts, it would be remiss to discount them.