Much is made of the flattening yield curve, as the spread between two-year and 10-year bonds has contracted again in the fourth quarter: the yield on UK 2-year gilts is now 0.44 per cent having started the year at 0.08 per cent, while the return on 30-year gilts is down 12 basis points from 1.73 per cent.
Low inflation has effectively kept a lid on long-term rates for some time and a flattening yield curve can indicate that expectations for future inflation or economic growth are falling. Since inflation shrinks the future value of an investment, investors demand higher long-term rates to make up for lost value, but post-referendum effects aside, it’s still far from certain the extent to which underlying inflation is feeding through into the wider economy.
Short-term yields may keep rising in expectation of the Bank of England nudging up the base rate again, but even seasoned market watchers will readily admit that the standard relationship between bonds and equities has become less indicative due to the unprecedented global monetary stimulus since financial markets unravelled a decade ago.
It’s worth noting that the money managers had raised their UK equity exposure in November, along with positions in emerging markets – and western economies don’t tend to record negative growth when emerging markets are in expansionary mode. However, UK investors have reduced allocations in US stocks, specifically those in the tech sector, where valuations are highest. If you’re now underweight in tech stocks, you might want to take a second look at the banking sector, much unloved and put-upon since the financial crisis. The Dodd-Frank reforms put in place following the crisis have survived the first act of the Donald Trump presidency, but changes in personnel at key government agencies could herald a rollback of banking regulation.
Some will be aghast at the prospect, but the US president is in favour of an industry-friendly approach which could underpin a rise in corporate borrowing. In concert with the tax cuts in train, and the proposed rise in infrastructure spending, it’s all about generating aggregate demand in the US economy. UK banks stand to profit from any relaxation in the reforms due to their relative exposure to the US sector, the attractiveness of which should be enhanced by proposals put forward in October by the European Central Bank that the continent’s banks set aside more cash to cover bad loans – that’s about €800bn and counting.
Bad debts aside, economies are progressing quite well in mainland Europe – at least in relative terms. A composite purchasing managers’ index for the eurozone put together by IHS Markit rose to 58 in December from 57.5 in November (readings above 50 denote expansion). Order backlogs of unfinished work increased even as factories across the region reported record gains in payrolls. So, presumably we needn’t worry unduly about Europe’s debt overhang given the marked improvement in economic performance, but there is one specific issue that could conceivably act as a bear market catalyst in 2018.
By midway through next year, BNY Mellon will dominate the clearing and settlement services for the $1.6 trillion US market for repurchase agreements (repos). JP Morgan, the only other institution that provides these services, decided to pull out of the market because capital requirements had become too onerous. Repos are essentially short-term loans granted to traders, usually in exchange for US government debt as collateral. It is a major source of liquidity in US security markets and the fear is that with just one clearing bank operating the US is far more vulnerable to a range of leftfield issues, ranging from natural disasters to cyber attacks. Anyone unfamiliar with repo trades and their importance to the US financial markets should consider their role in the downfall of Lehman Brothers. A sobering thought to take into dry January. Happy New Year!
Mark Robinson is companies editor
