"The foundation of every state is the education of the youth" Diogenes

The pound finally reacted on Monday to the current uncertainty that surrounds British politics. The FTSE 100 which can often react inversely to movements in the currency, due to its heavy exposure of overseas earners, this time reacted in tandem and lost ground along with the currency. So far Gilt yields have ignored much of the increased political uncertainty.

On Tuesday the latest inflation data for the UK economy reported that the Consumer Price Index remained at 3% in October, against economist expectations of another rise to 3.1% or as the Bank of England forecast 3.2%. Even this latest piece of economic data had a limited effect on gilt yields. Yields on the ten-year gilt remain well below the current rate of inflation.

Recent anecdotal data would suggest that equity market sentiment is improving, the fear now seems to be more in the bond market. The latest Merrill Lynch Fund Manager Survey reported an increasing number of fund managers polled believe equity valuations are toppy, however, despite this almost half the fund managers reduced their cash positions. Hedge funds net exposure to equities is at an 11-year high, according to the same survey, this must be a bit of a cautionary sign. The two major tail risks fund managers see a bond market crash or a policy mistake from a central bank, which some believe the latter would cause the former as in 1994.

It is not unreasonable that investors should fear the bond markets crash, however, we all know that asset prices tend not to fall when there is fear in the air. Bond prices suggest greed, with yields at current levels, but that does not appear the case. Equities are considered overvalued, if they are, this is partly because of what yields on bonds currently offer. The FT reported on Tuesday that there are still 11 trillion dollars of debt that trades on a negative yield. This combined with the current economic growth and a recent robust earnings season has been underpinning these valuations.

Macro market research seems to be consensual that there is nothing on the short-term horizon to destabilize risk assets. One would argue, there never is, until there is. One must be reminded that the IMF was very optimistic into the start of 2007, expressing the view that economic growth in China would continue to support global growth. Company CEO’s were optimistic for the year ahead and we know banks were happy to continue to lend. The gap between ten years and two-year Treasury yields is now 0.7%, that would suggest the bond market remains more cautious of US economic growth than the equity market.

Posted on November 14, 2017 .