Weekly Digest: Pulling teeth – markets stuck in the waiting room

Most weeks, when it comes to writing the Weekly Digest, it’s just a case of letting the words flow. Every so often, though, it feels like pulling teeth. This seems to be one of those weeks. Plenty is happening, but the storylines are stuck on repeat – and there’s only so much juice left in them. There’s the familiar escalation and de-escalation Middle East cycle; whether the AI-related capital spending will pay off; endless speculation over the UK government’s meeting its fiscal targets; and, this week, attempts to second-guess the policy decisions of central banks. All while navigating the quarterly company earnings season.

Bonds: going nowhere… slowly

A typical medium-risk, balanced portfolio has gone nowhere for the past couple of months (using the FTSE Private Balanced Index as an objective reference point). In an age of instant results, that’s pretty boring. Especially after three years of persistent growth, interrupted by the odd gut-wrenching decline. 

Bonds have been flat for longer, at least in total return terms. When checking the year-to-date performance of the sterling-hedged version of the Bloomberg Global Aggregate Bond Index on Friday, it was +/-0.00%! That means the loss of capital so far this year, as yields have risen, has neutralised any income received (at least across the global bond market as a whole). But there is a silver lining: the current yield on bonds can help offset capital losses. 

That was not the case when yields were close to zero. My colleague and bond guru Bryn Jones, Head of Fixed Income, points out that the redemption yield (the yearly return expected if the gilt is held to maturity) on a 10-year gilt would have to rise from around 5% today to 6.8% in three years’ time to wipe out the accumulated income. We haven’t seen that sort of yield since November 1997. It looks unlikely, provided bond investors keep pressure on the new Chancellor and the Bank of England remains alert to inflation threats. 

This is not a recommendation to pile savings into government bonds, but rather an observation that the starting point for bonds is more favourable than five years ago. Bonds remain vulnerable to inflation and fiscal mistakes. They also compete with equities and alternative assets for their place in a portfolio. Our long-term models continue to project better returns for equities.

There’s also the vexing problem of whether government bonds can still help steady a portfolio when share markets fall. In a world of higher and more volatile inflation, they’ll continue to struggle, compared with other assets, as central banks may have to keep interest rates higher, pushing bond yields up and prices down. They could come into their own again if the economy weakened sharply and inflation fell – provided that shock doesn’t pull the rug out from beneath the government’s finances.

Gilts have their cushion back

After five years of rising yields, 10-year gilts now offer more income to absorb shocks, though inflation and fiscal nerves still matter.

Equities: going nowhere… fast

Equity markets’ recent flat performance continues to mask a much more volatile atmosphere below the surface. Around late May, many leading technology stocks started falling, as doubts grew over whether their heavy AI spending would pay off.

There has been another source of pressure too: although investors expect inflation to be lower over the long term, longer-term bond yields have risen. This suggests a higher ‘term premium’, the extra yield demanded by investors to allow for increasing uncertainty over, say, fiscal responsibility – how prepared governments are to limit the gap between income and spending. Rising real yields increase the real cost of capital. That depresses the present value of future earnings, or, more simply, lowers the near-term price/earnings ratio (how much investors are willing to pay for each pound of a company’s current earnings). 

The effect is greater for companies with a higher proportion of their current value derived from future expectations. Technology companies are prime examples. A basket of hyperscalers (the companies funding the drive to carpet the world with data centres) peaked on 29 May and has since fallen 18%. The ‘Magnificent 7’ leading technology shares have shed 10%. The tech-heavy Nasdaq 100 Index has fallen 8% over the same period.

There was a time when the loss of such leadership would have sounded a death knell for the market. But the broader S&P 500 Index has declined just 2.5%, while the 493 companies previously deemed not so ‘magnificent’ have posted a marginal gain. 

Our own FTSE 100 Index has gained 4%, and not because of the oil majors. Of the 400-odd index points gained, a third can be attributed to the HSBC banking group, with almost as much to fellow banks: Barclays, Lloyds, and NatWest. Banks have been performing well globally. They’re generating significant cash in a higher-interest-rate environment, with limited loan losses. Those with capital markets operations are enjoying the boom in trading volumes and a healthy M&A and IPO environment (i.e. dealmaking and new stock market listings). More of the former than the latter in the UK, it’s fair to say. 

It’s usually wrong to get too pessimistic if banks’ shares are faring well, as banks tend to be useful barometers of the wider economy, and the MSCI World Banks Index has hit a series of record highs. Investors began to smell a rat a good 18 months before the global financial crisis hit in late 2008.

Still in the doldrums

The perfect scenario for investors today would be a conclusive resolution of the US–Iran war, as it would open shipping lanes in the Gulf and allow the free flow of critical commodities. Inflation-related concerns would melt away, and the risk of further increases in central bank interest rates would diminish. This verges on wishful thinking. 

We could also hope for definitive proof that the productive adoption of AI tools is accelerating, along with the willingness and wherewithal to pay for them. It’s too early to declare this outcome, and patience is required, even though our research suggests computing power demand will continue to grow. 

A final consideration is that US equities have historically been range-bound (moving up and down within a fairly narrow band) in the months leading up to the US mid-term Congressional elections on 3 November. They tend to be weaker than usual in mid-term election years: over the decades, the S&P 500’s median return from early August to Election Day has been 0%. The good news is that returns have usually improved once the vote is out of the way, with a median gain of 6% over the following three months. For now, then, markets may have to sit tight a little longer – uncomfortable, perhaps, but not necessarily in need of emergency treatment.