After a sharp sell-off in 2022, bonds have been range trading for the past 9 months.
In recent weeks, bond yields have pushed to the top end of the range (and briefly through the top end in Australia’s case). This is despite widespread expectations of a looming economic slowdown. Drivers of the recent rise in yields have been a combination of stronger-than-expected economic data, a stickier-than-expected inflation backdrop, and stubbornly hawkish central bank rhetoric. Technical/positioning factors also likely played a part in the recent up leg.
Benign US CPI Calms Bond Investors’ Nerves
Just when investors were becoming nervous, the rise in yields has reversed course in the last few trading sessions, helped by a significantly better-than-expected US inflation print.
Last week’s softer-than-consensus US inflation print was in line with our thinking on inflation and is an encouraging development for both bonds and equities.
Headline consumer price index (CPI) inflation fell to 3.0% in June, less than a third of the 9.1% peak in June of last year. Much of the slow down in inflation in recent months has been a result of the base effects, as the large increases in gasoline prices in the first half of last year have dropped out of the 12-month change.
The more stubborn Core CPI series also slowed significantly in June, and the 12-month change fell to 4.8%, well below the 5.3% level of May and 1.8% below last September's 6.6% peak.
Most strikingly, the monthly change slowed sharply; the 0.16% June increase was well below the 0.29% consensus and less than half the pace of the next smallest increase in the past 6 months. It represents the smallest increase since the surge in inflation began in March 2021.
Even with the slowing, estimated rents continue to be the major contributor to the measured inflation rate, however other data estimates suggest new tenant rents have been growing at or below their pre-pandemic pace for several months now. This suggests CPI rents will slow further in coming months. Excluding rents, the core CPI actually fell 5 basis points (bps) in June.
While we do not expect core CPI to come in quite as low in the next couple of months, the trend is encouraging and we expect the sticky core CPI prints of previous months are now behind us.
An ongoing deceleration in year on year (YoY) core inflation should see the market price in a definitive Fed peak (after a final late-July hike), with attention increasingly turning to the prospect of multiple cuts in 2024. This should be a supportive backdrop for fixed interest and equities as long as the growth backdrop does not deteriorate markedly. We continue to see a genuine hard landing as unlikely, although further slowing remains likely.
A Good Entry Point to Fixed Interest
While fixed interest markets continue to be choppy, we feel a significant peak is being marked out from which bonds can rally. From a fundamental perspective, we currently see fixed interest yields as representing good long-term value.
Our anchor for valuations is our estimate of a long-term neutral cash rate of around 3%. With the domestic 10-year yield at 4.06% (July 13), versus our long-term fair value levels of ~3.5%, we feel high quality bonds are offering an attractive long-term entry point.
With the rise in yields over the last 18 months, bonds are also well placed to fulfill their traditional role in portfolios as a diversifier/hedge.
Most obviously, high-quality bonds (government and investment grade corporate bonds) can insure portfolios against the risk of a larger-than-expected slowdown in economic growth.
A 50 bps rally in the long bond yield, back to our fair value area, would see a total return of ~7% (4% yield + 3% capital gain), based on a typical government bond portfolio with a 6-year average “duration”.
Bond yields have typically shown a correlation with economic growth momentum. The recent resistance to both slowing growth momentum and the cautious signals from many popular leading economic indicators is interesting. This may be a signal that the bond market is not particularly worried about the economic outlook. It may also reflect some residual concern around inflation, as echoed by ongoing hawkish central bank commentary.
Nevertheless, we still feel building hard evidence of slower growth and slower inflation are likely to drag bonds lower over the coming year, although perhaps not as low as in previous cycles.
Overweight Fixed Interest
In summary, more attractive valuations and heightened uncertainty over the 12 month economic outlook guided our decision to move moderately overweight on fixed interest at the beginning of July.
With the opening up of a positive spread to US fixed interest, long duration domestic bonds look particularly attractive, in our view. With an above average spread and the backing of strong balance sheets, high quality investment grade corporate bonds are also looking attractive, in our view.
Bonds and Stock Market Valuation - Resolving the Apparent Disconnect
Apart from their role as both a distinct asset class and a portfolio diversifier, the government bond yield is the underlying discount rate for equities.
The damage inflicted on equities (particularly US equities) in 2022 from the sharp rise in yields is testament to that influence.
In this context, it is interesting that we have seen some decoupling between equity valuations and bond yields recently. The US bond yield is up ~50 basis points from its March lows, while the US price-to-earnings ratio (PE) has risen from 17x to 19x. To some extent, we can explain the recent decoupling by easing concerns around the US banking strains, which had driven yields down sharply in March.
From this perspective, a large portion of the recent rise in bond yields (and some of the lift in equities) was related to the easing in fears around systemic risks flowing from the US banking sector.
However, the continued drift higher in US equity valuations suggests other factors have been at play.
As we discussed last week in Global Earnings Cycle Better than Feared, better-than-expected economic data has helped drive some moderate upgrades to US earnings. This is in contrast to the bearish consensus held at the start of the year, that the earnings downgrade cycle would accelerate.
Investor excitement around the artificial intelligence (AI) revolution has also undoubtedly helped boost valuation in the heavyweight US tech sector.
Overall, we feel the recent de-coupling between US equities and bonds can be explained by a number of fundamental drivers. Nevertheless, the valuation expansion of US equities bears watching.
However, in contrast to some of the more equity bearish interpretations of the recent decoupling, we expect the decoupling of equity valuations and bond yields to be “corrected” with some further retracement in bond yields, rather than any significant near-term retracement in equity valuations.
As a result, we remain constructive on US/global equities and constructive on fixed interest. The upcoming US reporting season will be important in keeping valuations at least steady. Our expectation is that it will be following from Q1 and be relatively supportive.
From a domestic perspective, growth prospects for the domestic market look a bit more muted, even though valuations look reasonable. This results in our neutral call on domestic stocks. As discussed, domestic fixed interest looks reasonably attractive from a valuation standpoint. This, combined with the tendency for bond yields to decline at this (slowing) point of the economic cycle, leads us to a moderate overweight.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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