It has been another week of volatile markets
More so in bonds than equities however, with government bond yields shifting higher once again as investors anticipate a “soft landing” and as a consequence, interest rates staying higher for longer.
The sell off in bonds has seen yields (which move inversely to price) reaching heights not seen since before the Global Financial Crisis. On Wednesday, the US 10-year bond yield reached 4.88%, a level last seen on 8 August 2007, the day before BNP Paribas froze €1.6 billion of funds due to “issues in the subprime market”. The moves higher in bond yields mean that some substantial mark to market drawdowns have now been incurred, and this does raise the prospect of “accidents” occurring. In the UK, the mini-budget debacle last September led to spikes in bond yields which caused havoc in the pension fund market.
Data from Bloomberg and Deutsche Bank serve as a reminder that bonds can see as much of a drawdown as equities in a rising rate environment. Bloomberg reports that a 30-year US government bond, issued in 2020 yielding 1.25% is now trading at 45 cents, having lost over half its value. The US 30-year bond traded at a yield of over 5% earlier this week. Deutsche Bank report that long dated index linked Gilts in the UK have seen even more extreme losses, down 85% in the past two years. There are some big losses out there for the market to absorb. But after such large moves, and with the economic trajectory likely to worsen, some bond valuations are looking compelling.
The economic numbers this week have seen the usual start of the month update on PMI data globally. The numbers from China stoked some optimism with signs of bottoming; we have also heard positive reports on strong consumer activity during the weeklong “Golden Week” holiday currently taking place. Closer to home, the UK data remained in contraction territory for both manufacturing and services, though the service sector was slightly stronger than expected. The numbers remain consistent with a contraction of around 0.4% for the third quarter. The eurozone data also picked up a little but remained in contraction. In the US, manufacturing remained in contraction but reached the “least bad” level since last November, while services remained in positive territory, albeit with a significant decline in the “new orders” component which is a useful leading indicator.
The data that moved the bond market the most this week was the US JOLTS data which shows the level of job openings in the country. This data has shown a notable drop off in recent months, and as a leading indicator, it was seen as a significant sign of cracks appearing in the labour market. However, the numbers published this week was much stronger than expected, suggesting continued labour market resilience, reversing the recent softening narrative. This in turn fuelled the “higher for longer” trade. Another market move worth a mention is the drop in the price of oil. Recently, we noted the oil price rally on supply constraints but high inventory and lower demand data from the US has reversed the recent momentum – the oil price has fallen back just over 11% so far this week. While weakening demand implies a softer economic backdrop, the fall back in the oil price is certainly a positive from an inflation point of view.
In politics, the US avoided a government shutdown after a last-minute compromise that leaves the government funded until mid-November. The compromise came at a personal cost to House Republican Speaker Kevin McCarthy, whose brokering of a deal with the Democrats angered Republican conservatives who saw a shutdown as an important step in imposing fiscal discipline on the government. As a result, the conservatives put forward a motion to remove McCarthy as speaker, and with Democrat support, McCarthy was voted out of office. This is the first time in history a speaker has been removed in this way. The votes for a new speaker begin next week. US politics remains as polarised as ever, including significant divisions within the Republican party. Government shutdowns tend not to have much impact on financial markets but do impact on economic growth over time and delays publication of economic data such as inflation and jobs data – never ideal not least when we appear to be at an important juncture in terms of interest rate policy. We will see who emerges as Speaker next week but there are significant questions over the ability of Congress to agree on a budget and avert a shutdown next month when the stopgap measures end, not least when the Republican party seems so focussed on their internal power struggles.
Long duration assets are suffering right now because the “soft landing” narrative has the upper hand in driving market sentiment. There are concerns over inflation failing to fall back to the 2% target, or central banks giving up the fight, and also worries about the amount of debt governments have issued in recent years that will now have to be refinanced at much higher rates. We should also be mindful that over a decade of quantitative easing is now in reversal, and a higher supply of bonds is coming to a market where central banks are now sellers, not buyers. Our own portfolios, which are overweight bonds and have a bias to longer dated government bonds, are feeling the impact of these moves at the moment but we do believe this positioning will ultimately prove correct as the impact of interest rate hikes comes to bear on economic activity. History shows government bonds perform strongly once the last rate hike is in – but for now, with the economic data proving resilient, markets are once again questioning if we really are at the top of the rate cycle.
For the moment, there are not enough “cracks” appearing in the data to convince investors that we are heading for a recession though again, we would cite historical data showing that the pass through from higher rates takes time, and as I mentioned last week, this cycle seems to be marked by exceptional factors that have helped cushion the impact of higher rates in the short term at least. Kelly will take a closer look at why we still feel justified in our positioning in next week’s update. Next week also sees our webinar on Thursday with Scott and I covering off fund performance, positioning and our macro thoughts for the coming months. Please register here.
Have a good weekend,
Regards,
Anthony.
