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Why equities are still attractive despite rising bond yields

01 November 2018

Eric Moore, manager of the Miton Income fund, considers whether rising bond yields undermines the case for investing in UK equities.

By Eric Moore,

Miton Funds

  The move from quantitative easing (QE) and near-zero interest rates to something more ‘normal’ is definitely a delicate transition and not without risk. But do rising bond yields undermine the case for owning UK equities, and higher yielding equities in particular? I believe the answer must be 'no'.

Firstly, equities have not ‘believed’ bonds for some time. In the UK, gilt yields have fallen for the last 20 years or more, while equities have typically traded within a 3-4 per cent range. Over the last few years of QE, the Bank of England has driven down gilt yields to extremely low levels, but the valuation basis of the UK equity market has stayed within its normal range. This is shown quite clearly in the chart below, which simply plots the UK 10-year gilt yield and the FTSE All Share index yield.

 

Source: Bloomberg

Equity markets have risen over the last few years, but not because of yield compression, but because of growth in earnings and dividends. It is growth that ultimately drives equity prices, not valuation.

Secondly, equities yield close to 4 per cent right now, so are towards the top of the normal 3-4 per cent range. This suggests that equities are cheap on an absolute basis.


Thirdly, bond yields are still very low compared to equity yields. Interest rates may be off their lows, but they are still miles below the yield available from equities. The below chart is simply the ratio of the two yields given above.

 

Source: Bloomberg

It’s apparent that before the credit crunch bonds yielded more than equities. In the 1990’s and 2000’s, gilts yielded twice as much, which is logical because bond coupons don’t grow, and the value of bond coupons are eroded by inflation, while equity dividends typically are not. But at the moment equities still yield more than twice as much as bonds. So, if gilt yields go somewhere back to ‘normal’, with yields approximate to nominal GDP growth, say 4 per cent, but the equity/gilt yield also goes back to its ‘normal’ ratio of 0.6x, then equities are 67 per cent cheap.

So, the move in interest rates has not, and need not, undermine the case for equities. But, a rising interest rate environment may have implications for which types of stocks do well. Specifically, ‘value’ styles should do better in a rising bond yield environment.

Over the last 20 years, ‘momentum’ factors have been the most successful. Assets that were going up, kept going up, which perhaps make sense if endless liquidity was being pumped into markets by Central Banks. ‘Value’ factors had their occasional quarter in the sun, but rarely strung a run together. This may change if monetary conditions continue to tighten.

It is intriguing that as the market has fallen in the last month, it has also rotated, with ‘value’ factors out-performing. This could be the shape of things to come.

Eric Moore is manager of Miton Income fund. The views expressed above are his own and should not be taken as investment advice.

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