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Monthly Commentary January 2018

Global factors influence UK yields 

No country is an island, not even island nations. Whilst there are idiosyncratic issues that impact individual economies such as governments and referendum results, international factors still have a significant impact on economic outcomes and financial markets. In January we saw the impact of this as better than expected economic data in the US lead to rising yields in the UK.

I have long believed that it would be very hard for UK yields to move significantly upwards until yields in Europe and the US also started to increase.  This was especially true with the Bank of England once again willing to look through exchange rate led inflation much as they did in 2009.  Whilst we have some control of our own destiny, we remain plugged into the global economy, and that of our two main trading partners, Europe and the US   It is no lie that a rising tide raises all boats and the global economy is currently in good condition.

The increase in bond yields in the US has been significant with 10 year yields moving up from close to 2% at the end of September to 2.8% at the end of January with more than half of this move coming in January alone.  This dramatic move has two main causes.  Firstly the Trump tax cut will have a stimulatory effect on the economy, at least in the short-term and, secondly, the US labour market is very strong, with unemployment at 4.1% the economy is close to full employment.  When combined market participants believe that these two factors will have a powerful impact upon wages and inflation which in turn will result in the Federal Reserve raising policy rates at pace faster than had previously been expected. 

Europe is at a different point of the economic cycle from the US, with the recovery nascent rather than mature. Unemployment has fallen from 12% at the start of 2014 to 8.7% currently; growth has accelerated to 2.6% in in the year to December 2017 and inflation has risen from -0.5% in early 2015 to 1.3% currently.  The rate of inflation is still below the ECB’s target of 2% and inflation expectations also remain muted so it is unlikely that we will see any increase in the ECB policy rates soon.  Crucially however downside risks have diminished and the fear of the deflationary spiral has, seemingly, passed.

The impact of these two developments on Sterling government bond yields has been important. Ten year yields have risen 1.1% from their post referendum low point of 0.5% and whilst yields were only this low briefly, 10 year yields are at their highest for 2 years.  As with moves in the US, 0.3%  of this move occurred in January alone. Yields at the longer end of the curve, which are more important for pension funds, also rose significantly in January with 30 year nominal yields increasing by 0.13%.  This pattern of short dated yields increasing by more than longer dated yields has been replicated across the US and euro-zone.

Unfortunately for pension schemes what the bond market gives, the equity market takes away.  Equities have gown fat on a rich diet of practically free money for the last 10 years. The prospect of rising inflation and strong global growth means that there is a growing possibility that the Federal Reserve is going to take away the punchbowl and increase policy rates more aggressively than had previously been forecast.   It is this more than any other factor that lead to the significant declines in equities that we saw at the start of February.

From the point of view of pension schemes it can be frustrating to see yields going up (having been told to increase their hedges over the last 5 years) whilst simultaneously seeing any funding  gains wiped out by falling equity markets.  At times like this I like to remind myself of 3 fundamental points.  Diversification is the only free lunch in finance; no single risk should be big enough to damage the funding ratio and investing is a long term game.

“Unfortunately for pension schemes what the bond market gives, the equity market takes away”

Robert Scamell, Senior Portfolio Manager

International 10 year yields:  Source: Bloomberg.International

The author

Robert Scammell

The month that wasn't

My commentary is a few days later than usual this month. In fairness, quite a lot happened in February and seems to have wiped away all the performance in January (and most of December at the time of writing this section…), so a commentary for January seemed rather less urgent in the end. Nonetheless, lets. 

January was a good month for most equity markets, with the global rally continuing its sweet notes from December, despite the perennial predictions of bubbles bursting (alas, we shall see where the last tumultuous week lands – stay tuned for February’s commentary…). Several stock markets reached new all-time highs (again) following a number of good news economic data releases indicating robust global growth, particularly from the US where the combination of employment data and the pricing in of Trump’s tax policy changes. Even a shutdown of the US federal government couldn’t halt momentum (only for a weekend until a short-term spending bill was agreed). The star of the show remained emerging market equities, particularly Asian emerging markets. However these dizzying heights were tempered by the UK, which saw some high profile failures, most notably the collapse of Carillion. The latest GDP estimates revealed that the UK grew faster rate than expected over Q4, but that growth over 2017 was the most disappointing since 2012, attributed by most commentators to uncertainty around the ongoing saga that is Brexit negotiation. Added to this, a strengthening of Sterling versus the Euro and the US dollar further detracted, given c70% of the earnings of FTSE100 companies is driven by overseas markets. 

There was – now characteristically – also an element of the bizarre during the month, with conflicting reports from US Treasury Secretary Mnuchin and President Trump that they were supportive and not supportive of a weaker UK dollar respectively. In any case, Sterling rose (and pared back a little), whilst the Euro retained its recent strength against a dollar weakened over the course of 2017 as a result of relative growth outside the US (particularly by the Eurozone).

The most relevant news from January related to signals from central banks in Japan, Europe and the US (the latter of which eventually contributed to February’s wobble). Japan heralded a milestone moment for its quantitative easing (QE) programme when it confirmed that inflation had finally hit target levels, and announcement that it would start reducing its purchases of long-dated Japanese government debt. The ECB indicated that its own purchase programme may be wound down by the end of 2018 and could consider “a gradual shift in forward guidance from early 2018”. Finally the minutes released in January from Decembers US FOMC meeting reinforced expectations for a rate rise in March and beyond. The combination of this led to a rise in global bond yields.

One could be forgiven for thinking that central bankers had found a way to taper without the tantrum and that we were beginning to see a semblance of normality with a bull in equities and a bear in bonds. February has chastened that optimism somewhat, but our view remains positive based upon the underlying improvements to the global economy; this view will be tested by the European earnings season, shortly to kick-off. 

What’s the action for pension funds? Look through the volatility strategically and with discipline apply the tactical axiom: sell the rallies and buy the dips.

market performance over January 2017, in sterling terms
January 2018

Source: Datastream.

The author

Nikesh Patel