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Tilney's Hollands: The risk/reward trade-off in bond markets is highly unappealing

Jason Hollands, managing director at Tilney, considers sentiment among central bankers over rate increases and what it could mean for bond and equities markets.

Jason Hollands

By Jason Hollands, Tilney
Monday July 17, 2017

Politics has undoubtedly weighed prominently on the minds of investors over the last year with the combination of the vote for Brexit, followed by the elections of presidents Donald Trump and Emmanuel Macron and latterly Theresa May’s disastrous snap election gambit backfiring.

Yet despite the undoubted significance of these political developments, the last couple of weeks have proven a powerful reminder that when it comes to the capital markets, the real movers and shakers remain the suited central bankers from the likes of the US Federal Reserve, Bank of England, European Central Bank and Bank of Japan who control the taps of global liquidity by setting interest rates and controlling the supply of money in circulation.

Across the globe central bankers have been carefully signalling to varying degrees that after years of ultra-loose monetary policy, including interest rates that were set at emergency levels in the wake of the global financial crisis and Quantitative Easing stimulus programmes, that there needs to be a path to “normalisation” as economic growth improves.

This effectively means that the free punch bowl that has kept the party going won’t be there forever and therefore the end of the age of record low borrowing costs is now in sight. Central banks after all need to rebuild their policy armouries so they will have some options to act again in the next downturn.

Recent comments from the European Central Bank President, Mario Draghi, marking a much more upbeat shift in tone over the growth outlook, alongside comments from other central bankers have triggered a major sell-off in government bonds over the last fortnight as prices adjust to expectations of higher interest rates to come.

It seems we are in the midst of a major inflexion point for markets, where the sun is setting on a long bull-market for bonds. As ultra-loose monetary policy reaches the end of the road, the policy baton has been shoved into the hands of politicians who are grappling with angry electorates. Governments across the developed world are under pressure to ease off austerity and loosen the fiscal purse strings, which may mean increased borrowing or higher taxes.

These are precarious times for central bankers who are having to walk a communications tight rope to guide expectations towards a gradual withdrawal from ultra-loose monetary policy without provoking a tantrum in the markets or choking off economic growth altogether. The risk of a communication failure is clearly high.

In the UK, where it has been a decade since the last time we saw a rate rise, the Bank of England faces a serious dilemma of slowing growth combined with rising inflation and the uncertainty around the UK’s future relationship with the EU.

The messages have been mixed and at times inconsistent but even here there has been a more hawkish tone in recent weeks with three members of the Monetary Policy Committee voting for rate rises at the last meeting, its chief economist Andy Haldane stating he would be ready to vote for a rate hike “relatively soon” and even the more dovish governor Mark Carney making an unexpected comment in a speech in Portugal that rate rises might become “necessary” in the coming months.

In this environment of an evolving tone from powerful central bankers and inflation back on the radar, there is potential for further volatility in the bond markets and, frankly, the risk/reward trade off in many parts of the bond markets is simply highly unappealing. So for now the relative attractions remain firmly with equities as earnings momentum is supported by improved global growth, especially the eurozone. But this won’t all be plain sailing as the effects of China’s last credit-fuelled stimulus fade and there is potential read-across to equities from the bond markets should a major central bank, such as the Fed, spook investors out of the markets altogether – equity markets have, after all, also benefitted from ultra-low borrowing costs.

A temporary pause in the bull-run for equity markets or even a short-term dip should not distract long-term investors. What does make sense is to focus on well-managed, financially robust companies with strong free cash flow generation, that are benefitting from structural growth, have globally diverse sources of earnings and which can generate repeatable inflation beating returns for shareholders.

Jason Hollands is managing director at investment management group Tilney. All views are his own and should not be taken as investment advice.

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