Since conflict in the Middle East broke out, bond markets have been buffeted by waves of optimism and pessimism. One moment, investors are buoyed by hopes of a peace deal, the next they are grappling with the realities of higher for longer oil prices, and what this could mean for inflation.
At the end of last month, bonds sold off especially sharply, pushing yields higher, particularly at the long end of the curve. As the chart below shows, the 30-year UK gilt yield passed 5.8 per cent, while the equivalent US Treasury yield hit 5 per cent – its highest level since 2007. While a US-Iran peace deal has seemingly been agreed, uncertainties over how quickly the Strait of Hormuz will reopen means attention is turning to what these sharp bond market movements could mean for the stock market.
Higher yields unsettle the stock market
To some investors, these high yields will look very attractive. After all, an income of almost 6 per cent is about twice the dividend yield on the average FTSE 100 share, albeit a 30-year conventional gilt offers no chance of inflation protection. Still, higher yields on other maturities can draw investors into bonds and away from equities, and this asset substitution could put stock markets under pressure.
Higher yields also pose a challenge for debt-heavy industries. As government bond yields rise, corporate borrowing costs also increase as investors demand compensation above the risk-free rate. Higher financing costs can weigh heavily on profitability in sectors such as real estate and early-stage technology.
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Peter Oppenheimer, head of European macro research at Goldman Sachs, warns that higher interest rates can also undermine the valuations of ‘defensive’ and ‘quality’ parts of the equity market, such as utilities and consumer staples. These sectors are so stable that they are sometimes viewed as proxies to bonds – but this means that they prove sensitive to interest rates.
Bond yields can also help calculate a company’s worth. Discounted cash flow models estimate the present value of a company’s future earnings by ‘discounting’ them at a rate influenced by government bond yields. As yields rise, so does the discount rate. This drags on the present value of earnings – and, in turn, the stock’s valuation. When most of a company’s profits are forecast to materialise years into the future, the impact is even more pronounced.
Joe Amato, equities chief investment officer at Neuberger, notes that equities have had a “phenomenal, albeit narrow run” since early April, driven by a rally in the semiconductor sector. But this has left market breadth at historic lows, with only a fraction of the S&P 500 outperforming the index since. He warns that “materially higher long-term rates may now act as a gravitational pull on soaring indices”.
A more benign scenario
There is a scenario where higher bond yields coexist happily with rising share price valuations. Analysts at Capital Economics think that a boost to productivity from AI should push up the ‘natural rate’ – the interest rate needed to keep the economy ticking over with on-target inflation and equilibrium unemployment.
According to the analysts, estimates of the US natural rate rose by as much as a full percentage point in the late 1990s and early 2000s, as the dotcom boom took off. Strong economic growth, soaring productivity, higher bond yields and a racing stock market all coexisted – at least for a while.
But history also warns us of a more troubling possibility. Neuberger’s Amato says that bond investors could become unsettled by high inflation, persistent fiscal deficits and rising government debt levels, meaning yields become unanchored. This would exert a ‘meaningful’ impact on equity valuations. The crucial factor will be economic growth. Markets can thrive against a backdrop of high interest rates, but generally only if those high rates are needed to keep a strong economy in equilibrium.