- Recent history shows that bond sell-offs have been good for shares. This need not remain the case.
- RIsing yields because of fears of rising interest rates are very different from rises because of stronger economic growth.
Many of you believe there’s a risk of a big sell-off in bonds. It’s easy to see how this might materialise. Yields are now being held down by promises from the Federal Reserve and Bank of England to keep short-term interest rates low. If, however, inflation proves to be more of a problem than they expect, they could withdraw such assurances thereby removing the anchor that is holding yields down.
Which poses a question: what would this mean for equities?
If recent history is a guide, it would actually be a good thing. My table shows that many sectors have done well in times of rising yields. Since 2004, the All-Share index has been positively correlated with gilt yields, rising by an average of over 10 per cent in 12-month periods in which five-year yields have risen by a percentage point. Many sectors – especially cyclical ones – have been even more strongly correlated with changes in yields.
| Sensitivity to 1 per cent rise in five-year gilt yield | |
| Transport | 23.6 |
| General financials | 20.0 |
| Travel/leisure | 19.4 |
| Banks | 18.2 |
| Mining | 16.1 |
| Construction | 16.1 |
| Retailers | 15.0 |
| All-Share | 10.4 |
| Oil & gas | 6.0 |
| Food producers | 5.1 |
| Tobacco | 0.6 |
| Pharmaceuticals | 0.3 |
Based on annual changes since 2004 Source: Datastream | |
Sadly, however, this is misleading. To infer from this experience that a bond sell-off will be a good thing would be to commit two mistakes.
One is the recency error: we must not assume that the recent past is a good guide to the future. Recent events are sometimes a biased sample of all possible events that can occur in future.
The second error is to forget the advice of George Mason University’s Scott Sumner: “never reason from a price change”.
The effect on equities of a rise in bond yields depends upon why yields rise. For most of the past 20 years the few bond sell-offs we’ve seen have been due to economic recoveries. These are circumstances in which we’d expect equities and especially cyclical stocks to do well.
But they are not the only circumstances in which yields could rise. If bonds sell off because of increased fears of inflation and higher interest rates it’s not at all obvious that shares would benefit. In fact, if investors fear that higher rates will lead to slower growth they might well dump equities. In such an event, the winners and losers from a bond sell-off would be the exact opposite to those in my table: it would be defensive stocks that hold up well and cyclicals such as construction that suffer.
We can put this another way. In theory, higher bond yields could hurt equities simply because they mean that investors apply a higher discount rate to future dividends. We’ve not seen this happen in recent years because rises in the risk-free discount rate have been offset by falls in the risk premium and rises in expected growth. But we’ve no guarantee that this will remain the case.
So, does all this this mean my table is meaningless?
No. It might well be a useful guide to the opposite risk, of a fall in yields.
There’s a danger that the current economic upturn will prove to be disappointing, perhaps because smaller companies cannot grow and might collapse under the weight of the extra debt they took on during the pandemic; or because consumers have fallen into more frugal habits; or because memories of the recession have a lasting effect in depressing animal spirits. If so, fears of rising rates would recede, dragging yields even lower.
Already, some straws in the wind point to moderating growth. In Germany, the ZEW survey shows that financial professionals’ optimism is falling. In the eurozone, growth in the M1 measure of the money stock has slowed recently; history suggests this is a lead indicator of slower output growth. And in the UK, purchasing managers report a moderation in manufacturing growth.
None of these signs are yet troubling, but this is how slowdowns begin. And if this continues, then yields might well fall back as would cyclical stocks.
It’s tempting here to add that fears of big rises in bond yields have been proven consistently wrong in recent years. Since the mid-1990s yields have generally undershot expectations.
Such a temptation must be resisted though. It’s another example of the recency error. Yes, those who warned us of bond sell-offs have in recent years been like the boy who cried wolf. But the point of that story is that the wolf did eventually eat the boy.
The point here is a trivial one, albeit one that is often overlooked because of our overconfidence and illusion of knowledge. The fact is that we know much less about the future than we like to think. We don’t know where bonds are heading, so we must diversify. Going all-in on equities is a dangerous bet. And cash is a useful protector against nasty surprises – in both directions.
