Have higher yields stopped spooking equities?

Thought of the day

by Chief Investment Office 15 Feb 2018

Stronger-than-expected US inflation data has pushed US 10-year yields to 2.93%, their highest level since January 2014. Yet, while last week fears of higher yields contributed to one of the worst weeks for the S&P 500 since the financial crisis, this week equity markets are rising, even though yields have continued to move up.

The change in dynamics is a sign of the instability in correlations between bonds and equities, with the market focus shifting back and forth between inflation and reflation. As technical selling has subsided, investors appear to be looking past inflation and rate concerns, and increasing allocations to equities in order to benefit from US tax cuts and further budget fiscal stimulus. Although this is positive for investors this week, dynamics are likely to shift again in the weeks to come.

As we look ahead, in our base case, we expect equities to move higher over the next six months, driven by strong corporate earnings growth. And we think that the bulk of the move higher in yields is complete: real yields have moved back to the top of their range since 2013, but a sustainable move higher is unlikely while pension fund bond demand, muted long-term growth potential, and aging populations continue to pressure real yields.

If our base case proves correct, the coming six months should be positive for investors holding portfolios of equities and bonds. But with markets switching focus back-and-forth between inflation and reflation, the ride will be bumpier than in the past. For investors, keeping a long-term perspective and keeping to their strategic plan will be crucial.

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