Equity markets took a decided turn for the worse in the early part of the week, a resurgence of the selloff in bonds being the catalyst, along with the continuation of the Greek saga. Bonds appear to be starting to price in the probability that deflationary pressures are easing and inflationary ones are starting to surface. This change in sentiment has come about as commodity prices have risen, marginally now outperforming equity returns so far this year. Hopes the US economy may bounce back in the second quarter along with signs of wage inflation starting to surface, this combined with an increase in manufacturing input and output prices suggests inflation expectations could start to pick up in the months ahead. Greece continues to make headlines, as the Government had to borrow 750m euros from the IMF on Tuesday to meet their obligation not to default to the IMF.
Gilt yields rose on Tuesday after better than expected industrial and manufacturing data. 10 year gilt yields are now over 2%. The taper tantrum as it has been dubbed could continue yet further as the large inflows of capital that have come into bonds over the past year, start to unwind. As we have pointed out on more than one occasion, rising yields are historically good for equity prices. However in the short term the adjustment to higher bond yields could continue to cause volatility in equity prices. German 10 year bund yields that only weeks ago came within a whisker of 0% rose on Tuesday to 0.68%.
Traditionally rising yields favour the sectors such as banks, mining and industrial shares as rising yields are a sign of an improving economy and increase in inflation expectations. Banks shares do better as banks profit from borrowing short and lending long. This should favour the FTSE 100’s performance relative to other indices due to its heavy weighting in these sectors. Sentiment for equities continues to swing almost daily between greed and fear; Tuesday seemed to suggest fear was back in fashion, after the excitement of the election rally.
The rally in equities is now into its 7th year and much is written about what impact the first move in interest rates in the US will have. When Bernanke first indicated that the Federal Reserve might look to taper its bond buying program, bonds and equities sold off in a similar manner to the current situation. When the move eventually came the impact was minimal, markets tend to react ahead of events and not at the time.
One of the most encouraging pieces of anecdotal evidence that suggests we may not yet be at the end of the bull market came from an old colleague, a strategist at a major investment bank. He tracks the number of buy recommendations from analysts relative to sell recommendations. Currently the number of buys relative to sells is as low amongst analysts as it was in 2003, and 2009. On both occasions we saw a rise in equities in the coming years.