We have spent the past two days reviewing/reading about what happens (or has happened historically) when yields rise, the Fed starts tightening and rates normalise etc.
Sadly and frustratingly the ultimate conclusion seems to be, ‘it depends’.
Many of the arguments for selling bond-proxies and HQG stocks during bull steepening phases are quite compelling, only to be quashed based on whether inflation expectations are rising with them (rising real rates being the ultimate sign of confidence on the real economic growth). While the Yield curve has steepened in the US, breakevens are back to 2% having been 2.6% as early as April. French breakevens have fallen from 2 to 1.64 and German breakevens have fallen from 1.94 to 1.54 since February.
One of the few (major) economies to see inflation expectations rising however is the UK. Low growth bond proxies in this market may continue to under-perform, see this chart of UK inflation linked gilts (inverted) vs. National Grid. With no cash-cover and being highly levered, it may suffer if traditional domestic bond-proxies are now to be shunned (not to be confused with those with genuine growth, pricing power and global sales footprints aka GSK).
None of the articles we read refer to these charts nor do they mention demography, perhaps the most important driver of fixed returns in Europe given retirees propensity for saving.
Adding to the confusion is knowing which historical comparisons to use. Is this a typical rotation where both bond yields and Equities rise gradually in an orderly fashion like in the 1960s, or is this more akin to the disorderly rise in rates, inspired by Greenspan’s tightening, in 1994 (or before that 1987)? Or perhaps it is 1943-1951 (Fed Treasury accord), where the Fed capped the 10 year at 2.5% and bills at 3/8ths (at the time Moody’s BBB corporates yielded less than now, and lasted the whole period and a few years afterwards, despite inflation soaring post end WW2. Equities soared).
The answer to this is it is too early to tell.
We simply don’t know. Yet.
The problem therefore for Equity investors is the outcome of these events will define your optimal strategy. Even more confusing is the blind screening some have used in support of their thesis. One (and to be fair they are normally very good) have included in their 10 year of historical data comparisons, a stock that only listed last year, Facebook.
While we can all articulate reasons for one outcome or the other, the only thing we feel comfortable doing is observing the current state of play, and reacting accordingly. Upon application of this, it’s too simple to sell European HQG/Bond proxies (least those with genuine dividend growth) just because the Yield-curve is steepening in the US. In the absence of rising inflation expectations (seen gold?) that could prove a costly strategy (especially if their dividends rise faster). The only major market where we have bull-steepening AND rising inflation expectations is the UK. Such could add pressure to those domestic bond-proxies with little cash-cover or dividend growth. National Grid is one to consider. When yields rise slowly and inflation expectations are contained, as today, then financials are the clear outperformers. Insurers should continue to outperform and you have to be selective/careful on cyclicals (refer our Templeton Basket which gives value comfort on a look through basis with potential restructuring and/or quality) and conversely, declining annuities like Fixed line Telcos and Utilities will underperform, and should continue to be avoided.
