I had ‘bond market concerns’ listed as #10 in my ‘10 Themes for 2022’ article earlier this year. In my opinion, sustained low interest rates had created one of the biggest bubbles in the world and it was due to unravel. It’s an issue markets are not well prepared for because bonds are seen as very defensive. Usually that is true. But we do not live in usual times and as interest rates rise there were always going to be adverse consequences for bond values.
The beauty of bonds is that they are far better at pricing risk than share markets. In fact, that’s really all they do. Bond holders assess the yield return they need to justify the money they lend you for the risk you present to their capital. It applies to corporations as much as countries. In that sense, it is comparatively simple and carries far fewer of the multitude of emotions and variables of share markets and individual stocks.
Since the US Federal reserve increased interest rates by 0.25% earlier this month, share markets have rallied strongly. In a market where interest rates are starting to increase sharply, you’d expect share markets to fall, not rise. Meanwhile, in just the month of March, the 2-year US bond yield increased significantly from 1.31% to 2.30%. It’s a big deal. Rising bond yields lead to falling bond values, and that is reflected in the Bloomberg Aggregate Bond Index being down around 10% from its highs last year.
So, one of these markets has got it wrong, and it’s not bonds.
The S&P500 is up 9% from its recent lows and in no way is any of the news better. If anything, the prognosis for global economy and equity markets is worse. Bond markets are working this out but share markets still haven’t caught on. The low interest rate party is over. Yet for some reason, presumably a combination of optimism, naivety and greed, equity markets are still in denial.
But it’s not just the fact that interest rates are going much higher. Usually, interest rates need to go up to slow a booming economy. The real problem now is that interest rates need to go up and the global economy doesn’t look good. There are signs that the Europe and even the US are headed for recession, possibly early next year. As the yield curve starts to invert, the bond market is telling us recession is increasingly likely in the US.
While many institutions and analysts are going to become fixated on the debate of whether we will or won’t see a recession, they are kind of missing the point. Whether or not its officially a recession it’s pretty obvious that those economies will slow considerably. Company profits will suffer, and jobs will be lost. None of that is good for the economy or share markets.
There is a theory that share markets are efficient. That they are correctly priced at any given moment as they adjust instantly to new information, as all information is known by the market and is assumed to be correctly weighed and priced. It is a great theory. The problem is it’s not how markets actually work in practice. You see just how inefficient markets are in times of geopolitical and economic crisis. All sorts of distortions occur. That is what we are seeing that now.
While I think much of the recent surge is money flowing out of higher risk areas across the world and into comparatively safe markets, it does seem that equity markets will continue to be in denial until they are faced with actual interest rate increases of 0.5% multiple times. Until then, markets appear willing to believe the worlds current economic problems will simply improve from here by themselves.
Unfortunately, that isn’t going to happen.
The good news for the Australia economy amongst all of this is that we produce, in abundance, most of the commodities that the world needs more of, from wheat to iron ore to energy. We are a safe and stable country with low sovereign risk. As countries and corporations around the world look for where to safely invest for the future, we are fortunate to be at the top of the list.
So far, the Australian economy has been broadly insulated from the same inflationary levels as other nations. That won’t last much longer as prices across the board jump to even more extreme levels. From a stock perspective we have held core positions in Woodside Petroleum, Santos and BHP for some time and we have increased our holdings significantly over the course of this year too.
Overriding everything else in the short term is the outlook for higher inflation and rising interest rates and ensuring that our portfolios are prepared for that eventuality. We continue to hold an overweight cash position and I expect the stock market to pull back as the economic reality sets in. That reality may be closer than many investors realise if bond yields continue their dramatic rise.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.