Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist
The recent selloffs in bond markets might have had a lot of investors reaching for their historical datasets to try and understand the broader implications for equity markets. Past big bond market selloffs have flowed over into equities, as falling prices lead to rising yields and bonds become relatively more attractive to investors.
Bonds do typically rise in the course of an economic recovery, primarily in anticipation of interest rate rises on the back of stronger economic growth and higher inflation .
Historically this has occurred in the early stages of most recoveries, including after the recession of the early 90s, the tech bubble of the early 2000s, the global financial crisis of 2008-09 and after the 2011-13 debt crisis. In the case of the latter – known as the “taper tantrum”, bond markets reacted violently to the mere suggestion from the Federal Reserve that it might taper its quantitative easing program (which they subsequently delayed till later that year).
As it stands, the early signs of recovery are likely to be amplified in inflation numbers by the effect of last year’s deflation dropping out of annualised figures, as well as bottlenecks in supply chains and higher costs for energy and raw materials. Bond markets are already responding to the potential spike – the question is how far and how quickly the rise in yield progresses.
What will this mean for share markets?
In the past, rising bond yields accompanying a recovery haven’t always been a problem for equities markets, so long as improving earnings keep pace. This is quite possible if bond yields rise slowly, but a panicked bond market can drive a consequent correction in shares.
Some equity classes will be more vulnerable than others. So-called “long-duration” shares – those that rely on long-term cash flows to justify valuations, such as tech and health care – are most exposed, as increasing discount rates undermine the value of those far-out cash flows. Yield plays – made attractive by spreads between bond yields and dividend yields on certain types of lower risk stocks, such as telcos and utilities – are also exposed but to a lesser extent. On the other hand, stocks that are likely to benefit more from a cyclical uplift to earnings will be more insulated from any flow-on effects.
In previous instances, such as 1994 and 2013, equity markets ultimately prevailed despite short-term falls in the wake of bond price crashes, although it took a while for Australian shares to retain lost ground in relation to the 1994 bond crash. Today, the broader economy is arguably less advanced in its recovery than in those examples, and central banks are far less likely (at this stage) to reach for the brake lever to rationalise overheating and inflation fears in the bond market.
Instead, most central banks appear to be looking through the short-term dynamics mentioned earlier, trying to stimulate sustained inflation – and this will require the economy to actually take most of the slack in the labour market.
The end of the bond boom
That said, we are probably witnessing a turning point in the 40-year downtrend in inflation and bond yields. The determination of central banks to drag developed economies out of their deflationary spiral is now matched by governments that have become far less averse to intervention in their economies as a result of the crisis, and have already embarked upon record fiscal stimulus programs with record debt issuance to fund them.
Other trends, such as the reversal of globalisation – which may increase the price of imported goods or goods that compete with imports – and decline in the proportion of workers within many economies will help drive this reversal.
The long-standing bull market in bonds is most likely over, and we appear to be on the cusp of a period of rising yields, although as with rising inflation this may take some time to play out.
For equities, there is some short-term danger if bond yields rise too quickly, but working in the other direction, the recovery has some way yet to run, and improving growth, rising profits and low interest rates in the interim support the case for still solid six to twelve months share market returns.
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