As we move into the final quarter of 2023 the movements in global bond markets, in particular developed market sovereign debt such as US treasuries and UK gilts, are likely to take the prize as the financial story of the year.
With losses on 30-year US treasuries greater than 50% from their highs, and some shorter maturities not far behind, what is the message from what are the biggest, most liquid markets from which many other assets are priced?
When moves happen quickly they can feel out of control. The rise in US treasury yields has been relentlessly upward, day after day. This can create an element of fear in markets and poses the question, what does the market know that we don’t?
The most objective and sensible explanation is a repricing of long-term inflation expectations, which will lead to higher interest rate expectations, reflecting a new economic model of 2-3% real growth with 2-3% inflation. On the basis that long-term yields, say 10 years, should gravitate towards the nominal – real plus inflation – growth of an economy (the so-called ‘Taylor’ rule for those who want to read more on this): this suggests yields of 4-6% and we are at current, near the middle of that range. This is different from the 2-3% growth and 1-2% inflation model of recent years – giving 3-5% yields – which was then weighed down by central bank intervention through quantitative easing (QE) to keep yields below the lower end of this natural level.
Effectively this means two things are occurring; first, the natural level of interest rates is moving up for economic reasons; second, central banks are no longer artificially pressing down on rates through QE with most enacting the exact opposite, quantitative tightening (QT). These two changes are happening simultaneously, which is leading to this aggressive repricing of some elements of the bond market.
Of course, there are more emotive and concerning explanations. These include the fragmentation of geopolitics to the point where historic buyers of, for example, US treasuries, no longer wish to partake as much. This is happening at a time when the US government is issuing a record amount of debt, creating a supply/demand imbalance. It could also be that inflation is not yet truly under control, and central banks will have to increase interest rates even further if they wish to reign it in.
On balance we would go with the objective explanation and suggest that, logically, this repricing makes sense knowing what we do now, and that whilst it has the potential to go further it is now within a sensible range. The more emotive explanations are worthy of attention though, especially when considering risk management.
The secondary question becomes, what are the consequences of this debt repricing? In my view, there are two impacts, one on the economy and one on financial markets.
With respect to the economy, there is an adjustment going on to a higher cost of borrowing. In the US, 30-year mortgage rates, the benchmark in that market, is now above 8%, compared to the average rate being paid today of around 3.6%. To give an idea of how impactful that is, a median house with an average deposit has a monthly payment of more than double the amount two years ago. Logically, this should result in lower house prices over time as affordability is key.
Equally in the corporate world, businesses and industries which rely heavily on debt to fund them are equally troubled. This includes real estate and infrastructure. To be clear, many of these businesses will be able to readjust through passing higher interest costs through to their end users, but some will not. London offices are an example of this, where some rent rolls do not cover the interest payments on the loans taken to buy or build the property. Some of these properties will be handed back to the lenders.
With respect to financial markets, they too must reprice to reflect higher yields. If an investor can achieve a 5% per annum return from owning US treasuries, then corporate debt needs to offer a premium to this, and it does. Equally equities need to reprice to increase their future returns to above investment grade credit. This can be done by lower prices, or higher growth from the companies from which equity is created, or by both. This restacking of returns has also come a long way, but it is hard to be certain it has ended especially in equities which, in certain markets, remain near recent highs.
Although dampened economic activity and lower asset prices is a downbeat combination, the readjustment process will take its course and then, we believe, reboot markets for future growth and returns.
Don’t worry, be happy
As Bobby McFerrin sang prophetically in 1998, in every life we have some trouble but when you worry you make it double: markets have a habit of taking worries and problems and doubling down on them.
It can seem to be an overwhelming world at times, especially when reading the news every day. What is consistently underestimated is the remarkable ability of society and markets to adapt to changing circumstances. Problems which seem intractable are resolved and each generation has the opportunity to live a better life than the one before. Whilst this may seem a superficial comment, it is a reminder that in investing, optimists tend to gather better returns than pessimists, and that equity markets when looked at over history have had many more good years than bad.
We continue to see several exciting and highly investable areas developing and expect innovation to accelerate in the years ahead. Whether it’s the ability to treat diseases such as obesity, Alzheimer’s and cancer, the use of generative artificial intelligence to make our lives more productive and interesting, or the continued efforts to decarbonise economic activity, all these are transformations at the early stage of their development. It seems likely that we will be talking about these in 10 years' time, and less so about some of the issues that trouble markets and society today.
As a final topic we note, and are attempting to understand fully, the potentially huge impact of new obesity drugs. These drugs, from companies such as Novo Nordisk and Eli Lilly, reduce cravings for certain types of food and drink, including alcohol. In doing this and thereby reducing calorie intake, these allow weight loss with all the positive side effects that it can bring. This ranges from the ability to do exercise, to reducing the probability of other diseases.
This could be a threat for businesses dependent on more consumption. For example, 35% of chocolate bars are thought to be eaten by only 9% of the population in the US. If these numbers are even remotely correct this could make some previously defensive businesses much less so. It could also lessen some of the challenges of climate change if we all consume less. Although the side effects of these drugs are currently too high for broad intake by the population this may not always be the case. Watch this space!
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.