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Monthly Commentary February 2018

Yields up, equities down.


The correlation between the returns on equities and bonds is one of the most fundamental in finance and can have a profound impact on pension funds.  Most investors prefer a negative correlation between bonds and stocks (where bond returns are positive and equity returns are negative or vice versa) in order to diversify returns.  However for pension funds, particularly ones with unhedged liabilities, negative correlations can be damaging since liabilities will increase at the same time as equities decrease.  The equity bond correlation came into particular focus this month as the steady rise in bond yields over the last year finally caused a reaction in equity valuations.

There are a number of reasons why higher bond yields may cause lower equity valuations.  When bond yields are close to zero investors are forced to take risk in order to generate a return.  In addition, it is possible to borrow money for free and invest it to earn a return.  There may also be a fear that low interest rates now may generate inflation in the future and therefore investors seek to buy asserts linked to real cashflows like equities and real estate. There is also a mechanistic effect by which the expected future dividends from holding equities are worth more in today’s money when yields are low thereby boosting valuations.

As noted last month, bond yields have been rising for some time but the move up in January and early February was particularly dramatic. In the US, continued positive economic data, particularly from the labour market, helped push 10-year yields up to their highest level in four years.  Closer to home, the release of the Bank of England inflation report on 8th February was deemed hawkish by market participants and precipitated a further rise in yields at all maturities.  In the inflation report the MPC raised their growth forecasts for 2018 and 2019 and noted that ‘whilst modest by historic standards the pace of UK growth is more than sufficient to use up the limited slack remaining in the economy.’  It is the hint that spare capacity is close to be used up that has proved to be critical. 



“The MPC have previously stated that changes in the structure of the economy since the financial crisis have led to the top speed of the economy diminishing. ”

Robert Scamell, Senior Portfolio Manager

The MPC have previously stated that changes in the structure of the economy since the financial crisis have led to the top speed of the economy diminishing.  This means we can no longer grow as quickly as before without generating inflation. With spare capacity already diminished and the top speed of the economy reduced any increase in growth is likely to be inflationary, this in turn is liable to prompt an increase in the Bank’s policy rate.  With market participants revising their views on global yields market participants also revised their views on equity valuations.  With the BoE signalling that UK policy rates would also rise there was little to stop a similar revising of views on UK equity valuations.

Of course the relationship between bond prices and equities is, in practise, more complex than a deterministic correlation. It would be possible to write an entire thesis on the subject – indeed many people have. However we do know the relationship is prone to change and that this can have significant implications for pension funds.  During the pre-crisis years high bond yields and high equity prices lead to low deficits and contribution holidays; in the immediate aftermath of 2008 equities tumbled but yields actually remained relatively high by today’s standards with the result that liability valuations were contained.  It was only during the sovereign debt crisis of 2011 onwards that valuations were hit by falling yields.  Fortunately, massive QE programmes and zero interest rates led to increasing risk asset prices which saved many pension schemes from even more severe problems.

The correlation between bonds and equities may return to its prior relationship and we may have high yields and high equities, however that also implies the possibility of low yields and low equities.  As ever the advice is to hedge unrewarded risk and diversify your portfolio. 


 Graph 1 MC Feb-2018

The author

Robert Scammell

Not a post-apocalyptic dystopia…

February heralded the first significant correction to equity markets during what is (still) getting closer to being the longest US expansion in history. And the expansion is marching on.

The combination of positive economic data in the US and Brexit transition confusion in the UK led to rising yields in the US, UK and Europe. In the UK, comments from Mark Carney (BoE Governor) stating that monetary policy would need to be tightened earlier and by more than previously indicated increased the markets’ expectations for a rate rise as early as May. February was something of a flurry in terms of Brexit speeches, but I think we all remain baffled and confused as to whether anything meaningful was revealed. However it was the source of my favourite journalistic column in some time, with this gem from Robert Shrimsley in the FT: “However bad it may be, Brits can rest easy that Brexit will not be a post-apocalyptic dystopia characterised by societal collapse, murder and Jacob Rees-Mogg and his gang terrorising the roads in pinstriped suits and Bentleys.”

Coming back to markets, it seems the main trigger to the sell-off was the better than expected US labour statistics, which could potentially open the door to more rate rises than the three already priced into markets to offset higher inflation expectations. The anticipation of rising borrowing costs led to a repricing of the relative value of equities over bonds. Following this initial trigger, there were many reasons suggested for the severity of the equity market correction. “Flash Crash” it was not, but there is good reason to believe that a large component of the falls were driven by the unwinding of trades which relied on low equity volatility, which swung on shifting sentiment, and further exacerbated by leveraged products tied to a continuation of low volatility (ie the VIX). In any case, the correction was swiftly accepted and stabilized over the following weeks with global equity markets (overall) recovering somewhat during the month to end only modestly negative in sterling terms.

“This is the second time since I’ve been writing these commentaries that I’ve been confronted by the limitations of attempting forecasting versus that of the Simpsons. ”

Nikesh Patel, Head of Investment strategy

The US equity market, suffering the most initially (the Dow suffered its biggest one day points fall in history), pulled back to almost flat for the month (in sterling terms); mirroring the performance of the US Olympic Curling team who inexplicably (to the Swedes) took Gold from the depths of a near elimination. Incidentally, this is the second time since I’ve been writing these commentaries that I’ve been confronted by the limitations of attempting forecasting versus that of The Simpsons (Yes, I’m referring to the yellow cartoon characters). The writers of that show predicted a US / Sweden curling final and the Gold eight years in advance – a foresight those of us looking at markets would aspire to!

What was striking to us about February was that the burst of volatility, which reached its highest level for more than 2 years, was a shock to investors; for most of us, it was a return to (more) normal times, and the last 2 years had been the aberration. And it’s important to put the “correction” into context – the markets rose more in December alone than fell during February. Our overall preference remains for equities over bonds, and we look through the short term volatility as a source of opportunities for the nimble. We are keeping watch on inflation and in particular the risk that inflation rises quicker than expected.


Graph 2 MC Feb 2018

Source: Thomson Reuters Datastream


Graph 3 MC Feb 2018

Source: Thomson Reuters Datastream



The author

Nikesh Patel