What next for stocks as bonds crash?

This year the price of the ten-year gilt (Treasury 4.5% 2032) has fallen by 25% and that of the 30-year gilt (Treasury 3.75% 2052) by 50%. Anyone who thought that they could protect themselves from inflation with index-linked gilts has had a shock: the price of the FTSE Actuaries UK Index Linked Gilts Over 15 Years Index has fallen by 60%. At the start of the year, investors were massively over-paying for inflation “protection”.

Investment crashes are normally associated with high-risk equities (technology stocks in 2000-2003, financials in 2008, and the Nasdaq this year), but not with government bonds, which are supposedly suitable for widows and orphans. What also marks out this crash is that everybody predicted it: commentators, pundits, strategists and asset allocators. As a result, no sane investor owns long-dated gilts – not direct investors, not funds managed by wealth managers, financial advisers or defined-contribution pension schemes. So who pushed the price of gilts into ridiculously overvalued territory?

Quantitative easing by the Bank of England was a big factor. In its desperation to pump liquidity into the system (and thus cause the inflation we are now seeing), the Bank was not concerned about the price it was paying, so sellers took it to the cleaners. The other big contributors were pension schemes using a strategy known as liability-driven investment (LDI). They deluded themselves into thinking they were matching the long-term liabilities of defined-benefit pension schemes rather than simply speculating.

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Now, the Bank of England, the Treasury, the chancellor and the Financial Times are in a panic. What must be done to bring gilt yields down again, save the LDI schemes and the Bank’s reputation? The Institute for Fiscal Studies thinks the government will have to announce a fiscal tightening of £60bn, which means major cuts in spending, to convince investors.

Better control of government spending may be necessary to improve the productivity of the UK economy, but a rush to cut would slash spending in the wrong areas, such as investment. It would not encourage investors to see ten-year gilts yielding 4.5% as good value. Nothing would. Gilts now yield more than US Treasuries, as they should, given the strong dollar, lower inflation in the US, American self-sufficiency in oil, the status of the dollar as the world’s reserve currency and a benign political outlook. But the current margin of 0.6% is not enough.

Investors are always reluctant to return to the scene of a crash. Gilts will have to look unquestionably cheap to attract those who have been avoiding them for years. That means yields not just above current inflation but with a margin that takes account of the future. With inflation still hovering around 10%, we are nowhere near that point yet. Even if inflation does come down, investors will be sceptical about the longer term; this government will need to buy votes with tax cuts and spending. Everyone now expects a Labour victory in 2024; Labour governments are better known for tax-and-spend than frugality.

The Treasury may well be wrong

The good news is that the highly-regarded Centre for Economics and Business Research (CEBR) recently produced a report saying the government’s fiscal balance will move to a small surplus in three years. By implication, it rubbished the Treasury forecast, pointing out that freezing tax allowances for four years will significantly raise revenues. It said that with prices falling fast, the cost of the energy price cap cost might be zero – a forecast made before the cap was reduced from two years to six months.

If true, this would ease the pressure on gilt yields relative to US Treasuries. If the Bank of England raises interest rates more aggressively, that might also help but money markets have stopped paying attention to the Monetary Policy Committee. Market rates are well above those indicated by the Bank of England, so a change of tack might not impress the gilt market.

Without a sustained move down in US Treasury yields, there is little hope of lower gilt yields. A range of 4%-5% is likely to persist. This is very bad news for LDI schemes, whose sponsors, promoters and managers might want to think about escaping to a country with which Britain does not have an extradition treaty, such as Russia, Iran or Venezuela.

Equity markets have struggled in 2022 but a return of -7% for the FTSE All-Share index and -8% for the MSCI World index is hardly in the same league as the slump in bonds. Equity markets are certainly influenced by the bond markets and unlikely to rally until global bond markets stabilise. However, equity investors never believed that the bond market was being rational. If they had, markets would have gone much higher. The US Federal Reserve valuation model, which compares earnings yields to bond yields, would have suggested a peak US market valuation of over 100 times earnings. With ten-year yields at 4%, it points to a price/earnings ratio of 25; yet, according to analyst Ed Yardeni, the prospective multiple is just 15.

JPMorgan estimates that the forward earnings multiple of the FTSE100 index is a mere nine, with 70% of earnings derived from overseas and thus benefiting from weaker sterling. The yield of the FTSE 100 index is 4.15% but dividends can be expected to rise faster than the rate of inflation in the medium to longer term.

It would take a major fall in corporate earnings or a further major rise in government bond yields to undermine equity valuations, and these developments would have to be believed to be more than temporary. Bond markets may now be reasonably priced, but equity markets are much better value.

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