Still got the blues
The Summertime Blues we wrote about a month ago are still here: stocks and bonds fell further in September. We think investors are still digesting the prospect of interest rates staying "higher for longer".
Policy rates have slowed their ascent – the ECB hiked, but the Fed, the Bank of England and the SNB all left rates on hold at their most recent meetings, and all four are sounding increasingly "data dependent" or pragmatic – but the prospect of falling rates is receding further into 2024, even as disinflation is becoming more visible, and yields have been drifting higher further along the curve.
Bond yields have hit new cycle highs – 10-year yields in the US and UK have reached levels not seen since the GFC, and 10-yr bund yields are at 2011 levels – and major bond indices are looking at a third consecutive annual decline in nominal terms, which would be unprecedented.
A media which is usually only too happy to talk of collapse and slump seems to have missed this big story unfolding slowly under its nose: as bond yields have normalised, the cumulative decline in bond values in real terms is on a par with any stock market crash – arguably greater, given bonds' supposed status as "safe haven" assets.
The UK gilt index, for example, has lost roughly half its inflation-adjusted value since mid-2020. And ironically, it has been inflation-linked gilts which have fared worst. In early 2021, in "Inflation: Revision Notes", we argued that linkers and other inflation-indexed bonds are not a good hedge against inflation when real interest rates are rising, and so it has turned out.
We have said this before, but it bears repeating: almost all the normalisation in bond yields has been driven not by higher medium-term inflation expectations, but by a return of real yields to more sensible levels. Thus the biggest inflation surprise in forty years has had little effect on forward-looking inflation expectations, but has instead driven a big reappraisal of the real yields seen implicitly as needed to deliver such stable inflation. And linkers, TIPS and the like are primarily a play on real interest rates, not short-term inflation.
When yields have travelled such a distance – the single most important interest rate in the world, the yield on that 10-year US Treasury note, has now risen by four percentage points from its 2020 low – it would be foolish to draw any lines in the sand, to try to "catch the falling knife". Economists' and central bankers' confident talk of "R*" is looking a bit pretentious: this is no place for spurious precision in either measurement or thought.
That said, a market which was egregiously expensive when nominal yields were negligible (in many cases, negative) is no longer obviously so. Those real yields are back close to the likely trend growth rates in their respective economies – our own, imprecise notion of "fair value" in this context – and even in the eurozone are starting to offer plausible wealth preservation for the first time in years.
Yields can easily overshoot – and prices undershoot – and may be starting to do so now. But for long-term investors, value is returning to bonds.
For now at least, we think stocks still have the edge. The resilience of corporate profitability – which stayed high even when bond yields had collapsed – and reasonable valuations throughout (even now, with discount rates back to normal) have made them the asset best-suited for long-term wealth preservation. The world has not gone ex-growth, and despite our environmental concerns – arguably, partly because of such concerns – that growth remains as open-ended as ever. But the gap between plausible stock and bond returns is smaller than it was…