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I have never been a huge fan of bonds, but I cannot ignore the recent worrying rise in bond yields. UK 10-year bond yields were below 3.8 per cent last September and are now 4.8 per cent.
In September, the US Federal Reserve published a “dot plot” predicting interest rates would fall to 3 per cent by December next year. That prediction is already toast. Since November’s presidential election they have risen from 4 per cent to 4.7 per cent.
Governments are suddenly having to pay lots more to borrow. The explanations can be confusing. Some say bond yields have risen because inflation has — yet the official figures here have been low. Others say they are anticipating a rise in inflation. Whichever way, bonds seem to react to inflation announcements — last week a “bad” US job number, this week a “good” US inflation number.
It is perplexing, as the pressures are going to hang about. President Trump’s tariffs and unfunded tax cuts may be inflationary, but the UK economy faces the opposite challenge — low growth with persistent, if modest, inflation. A fall in sterling might raise inflation a bit on imported goods, but the rise in the dollar reduces US inflation by the same argument. It is unusual for bond yields to rise on both sides of the Atlantic for almost contrary reasons.
An alternative view of why bond yields have risen comes from simple supply and demand. Most Western countries have rapidly rising social costs and slowly rising tax receipts. This leaves them not only having to issue more bonds but, in the case of the UK, relying increasingly on overseas investors to buy those bonds.
The rise in bond yields and fall in sterling brings memories of past crises. In 1976, Labour chancellor Denis Healey was heading to the annual meeting of the IMF in Manila. Between him leaving central London and reaching Heathrow airport, sterling dropped sharply to a record low against the US dollar. He turned back and shortly afterwards began writing an application for an emergency loan from the IMF.
He faced much higher levels of inflation and inflationary pay demands, but — as today — needed to issue lots of gilts to pay the government’s bills, leaving the bond and currency markets vulnerable to faltering confidence among overseas investors.
Do not expect leniency from bond market investors. They are heartless animals! They prey on weakness and will demand public spending cuts. They did in 1976, in effect forcing interest rates to rise to 15 per cent. They are not politically biased — they showed no more sympathy towards Norman Lamont in 1992 when the UK tried to join the European exchange-rate mechanism.
There is another important point to make. Bond yields do not just give an (albeit confusing) perspective on the macroeconomic picture — they should also affect our appetite for risk as equity investors.
We must always benchmark the reward and risks we take when buying shares in companies against what we can get by leaving the money in the bank. Rising interest rates lift the hurdle.
Everyone agrees that UK equities look cheap. However, with rates so high, we really need to see a long-awaited recovery to justify investing now. Can Rachel Reeves do anything to spark one?
The rise in bond yields limits her options. The Office for Budget Responsibility’s forecasts of bond yields used in last October’s Budget are already wrong, and the cost of funding existing debt has probably already exhausted her wriggle room ahead of the Spending Review.
So I struggle to see what the chancellor can do to give a bounce to UK equities. Funding public spending through taxing the private sector is an unconvincing growth plan. And without growth the government deficit will need to be funded by more gilt issuance. This is the vicious circle of stagflation.
And what about your US equities? The picture in the US is very different but no more reassuring. Many say US equities are expensive. It is easy to think that the soaring Magnificent Seven stocks that helped drive the S&P 500 up 25 per cent last year are all now overpriced.
Google and YouTube owner Alphabet, which we hold, currently trades on about 21x earnings. Fast-growing Nvidia shares (another holding) trade on about 30x earnings two years out, which does not look ridiculously priced to me — unlike Tesla, on 130x earnings.
These stocks tend not to be buffeted by changes in bond yields, inflation or short-term economic news. The stories in these stocks remain credible, and the numbers are not off-putting. But it would be entirely understandable if anyone who has enjoyed the huge bull market in US equities over the past 15 years chose to bank some gains, head to the beach and watch the early months of the Trump show from there.
Most of my money is in our own funds. Though we have not booked a beach house yet, we have taken some gains from big winners such as Nvidia. We currently have 6 per cent in cash — high for us, but it gives firepower to seize glaring opportunities that open up at times like this. We will not let cash in the fund burn a hole in our pocket. Opportunities to invest will emerge somewhere in the world.
What does all this mean for those who review their finances and make lump-sum investments at this time of year? I would say that there is nothing wrong with putting your money on the investment platform to bag your Isa and pension allowances and then leaving it in cash for a while. The challenge is knowing for how long.
I have faith in equities as long-term investments. It is dangerous to be out of the market too long and difficult to time an entry. If you want to walk away and forget about everything, consider setting up monthly investment requests to drip-feed your money in.
Alternatively, you could invest in a good, equity-heavy, multi-asset fund or an equity fund where the managers have the scope to sit on cash in times of heightened uncertainty. You might think this would be all equity managers, but most will always be fully invested, regardless of market conditions. They take the view that investors themselves want to make the decisions on when to hold cash.
Finally, for those nervous about the unpredictability to come in the US with the inauguration of an emboldened Donald Trump, global politics and the broader macroeconomic picture, I would say this uncertainty and sense of threat is nothing new. Yes, I advise caution, but you can also overdo it.
Simon Edelsten is chair of the investment committee at Goshawk Asset Management
https://www.ft.com/content/86385452-6aab-4dcc-b2a5-46af2b9df582
