What next for stocks as bonds crash?
Despite the slump in prices, UK government bonds remain too expensive. Stocks are much better value, says Max King.
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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
Don’t forget to grab your tickets for the MoneyWeek Wealth Summit on 25 November 2022 – we’ve got some brilliant speakers lined up, and given everything that’s going on, we’ll have an awful lot to talk about.
Book your place now at moneyweekwealthsummit.co.uk!
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
-
Cash hoarders take total UK savings to £2 trillion – why aren’t we investing?
Investment-shy Brits are hoarding huge amounts of cash in their savings accounts. We look at the case for saving versus investing.
By Katie Williams Published
-
The MoneyWeek Christmas Charity Appeal: who are we supporting and how to donate
This year MoneyWeek is supporting YoungMinds, tackling mental health for children and young people. Here’s why we are partnering with YoungMinds and how you can help.
By Kalpana Fitzpatrick Published
-
Halifax: House price slump continues as prices slide for the sixth consecutive month
UK house prices fell again in September as buyers returned, but the slowdown was not as fast as anticipated, latest Halifax data shows. Where are house prices falling the most?
By Kalpana Fitzpatrick Published
-
Rents hit a record high - but is the opportunity for buy-to-let investors still strong?
UK rent prices have hit a record high with the average hitting over £1,200 a month says Rightmove. Are there still opportunities in buy-to-let?
By Marc Shoffman Published
-
Pension savers turn to gold investments
Investors are racing to buy gold to protect their pensions from a stock market correction and high inflation, experts say
By Ruth Emery Published
-
Where to find the best returns from student accommodation
Student accommodation can be a lucrative investment if you know where to look.
By Marc Shoffman Published
-
Best investing apps
Looking for an easy-to-use app to help you start investing, keep track of your portfolio or make trades on the go? We round up the best investing apps
By Ruth Emery Last updated
-
The world’s best bargain stocks
Searching for bargain stocks with Alec Cutler of the Orbis Global Balanced Fund, who tells Andrew Van Sickle which sectors are being overlooked.
By Andrew Van Sickle Published
-
Revealed: the cheapest cities to own a home in Britain
New research reveals the cheapest cities to own a home, taking account of mortgage payments, utility bills and council tax
By Ruth Emery Published
-
UK recession: How to protect your portfolio
As the UK recession is confirmed, we look at ways to protect your wealth.
By Henry Sandercock Last updated