Rise in yields makes decisions harder

Published in The Sunday Times on August 27th 2023.
 

Stock markets have been on a charge in 2023. The S&P 500 put in an exceptional performance in the first seven months, rising more than 19% in US dollar terms. A better-than-expected mid-year earnings season has buoyed markets, but the real enthusiasm appears to be driven by the realisation that inflation has dissipated without causing a recession.

There’s a debate as to whether the US central bank (the Fed) was responsible for this or whether the disinflationary process was driven by dissipating supply-side effects from the pandemic and the war in Ukraine. That’s a topic for another day. 

Beware though. August has a bad reputation for stocks. And it seems to be living up to it so far. People take holidays in August – even greedy investment folk. Markets tick along with diminished activity and depth, so when surprises come along, the absence of senior staff may add to the violence of market moves.

August is a great month for markets historically

However, contrary to much uninformed analysis on the Internet, August is actually the best month for stock market returns. According to Bill Schwert, emeritus professor of finance at the University of Rochester, August has averaged the highest returns of any month at +1.45%. I’ve written before about this and the likely reasons why. In short, the likelihood is that it’s just random. There is no story.

But there is an unfolding story this August. However, it relates more to bond markets, than stock markets.

Rising bond yields

Globally, yields on major fixed-income benchmarks have risen a lot this month. The US 30-year reached its highest point since 2011 at 4.42%. The US 10-year reached 4.31%, just a fraction away from its 2022 peak. In the UK, the 10-year gilt is yielding its most in 15 years - even eclipsing the levels reached during the Gilt crisis that ensued after the Truss/Kwarteng budget debacle. In Europe, the German 10-year at 2.6% - is at its highest since 2011, save for a brief spike in March this year.

Much has been written abo ut the interest rate environment in 2023. Nine consecutive rate increases since mid-2022 by the European Central Bank (ECB) has brought the deposit rate to 3.75%. Similarly, the Fed has raised rates even more aggressively to 5.25%. It’s not surprising for bond yields to rise when interest rates rise.

But the latest moves have come at a time when central banks are close to the peak - there’s now a general consensus that central banks are essentially finished hiking.

Not driven by inflation

The recent rise in bond yields is not being driven by inflation. Implicit inflation expectations derived from the difference in yields on Treasury Inflation Protected Securities from their nominal bond counterparts show remarkably consistent inflation expectations. The rise in long-dated bond yields has been driven by real yields which are now close to 2%, having been negative up to May this year.

The market’s current assessment is that recession risks have all but disappeared. The economy is simply hotter than most investors expected. A stronger economy, and the associated risk of a renewed inflation wave, means interest rates may well stay higher for longer, and so markets are revising their expectations.

It’s probably not a coincidence that the rise in yields has been accompanied by a sell off on the stock market, with technology bearing the brunt of it. Valuations become harder to justify as yields rise. So, the recent stock market setback seems justifiable.

Rising yields raise the bar for risk assets

Rising yields set the bar higher for risk assets. If I can get 3.75% on my Euro money market fund with little risk (bank deposit holders be aware), my expected return from moving up the risk curve gets higher.

Reaching for yield and chasing after performance were things a conscientious investor would never stoop to do. In the age of negative rates, those transgressions against good practice became almost compulsory. That game has changed. With 3.75% on offer ‘risk-free’ clients are opening liquidity accounts in their droves – no need for any more difficult decisions!

There’s some cognitive dissonance going on here. You know that inflation is running at well over 5%, but willingly accept a decline in real value by rationalising it as a strong nominal return. It’s not 3.75% risk-free. It’s only risk-free if your metric for risk is short-term capital loss or volatility. There’s no long-term investor for whom this is the appropriate measure of risk.

Defaulting to cash is a decision – don’t kid yourself

Warren Buffett once described investing as “forgoing consumption now in order to have the ability to consume more at a later date.” The measure of risk implicit in this definition is inflation. It is unquestionably the best definition of investing I’ve ever read.

Don’t kid yourself into thinking you’re making an investment decision by putting money into short-term Government bonds or money market funds. You’re not. You’re putting off a decision. Don’t put it off too long or as Buffett warns, you’ll be consuming less at a later date.

Source: Data is sourced from Bloomberg as at market close 31st July returns are based on total indices in local currency terms, unless otherwise stated. Bloomberg.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on Twitter @gconno1.