The inverse relationship between bond yields and equities

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SIMON BROWN: I’m chatting now with John Stopford, head of multi-asset income at Ninety One. John, appreciate the time. Bond yields. Typically when bond yields are moving higher, which is certainly what we’re seeing across most developed market economies, are usually bad for shares. That’s kind of, Equity 101 in my layman thinking.

Talk us through why higher bond yields are typically negative for equities.

JOHN STOPFORD: You can look at it in one simple way – which is, as an investor, you have a choice between different investments, and if bond yields rise, their future return is essentially higher.

And so, to some extent, equities then need to adjust in price to make their future returns higher. So typically you would expect higher bond yields to be associated with lower equity prices. That’s probably the most straightforward explanation.

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SIMON BROWN: I’ve also got an opportunity here where I can go and buy a US 10-year for 5%. My risk is the US government – which I think I can say is pretty much nothing. In US dollars, that’s a good return, and a return that I haven’t seen in US debt in over a decade.

JOHN STOPFORD: Yes, that’s right. So we are now being paid a decent amount to lend to governments. That obviously partly reflects higher inflation, higher interest rates, higher growth – and to some extent more borrowing by governments. So governments have to pay up to issue their debt.

But yes, the prospective return looks pretty attractive.

And if you look at the inflation-linked bond markets – the part of the bond market where you can earn a yield above inflation – those are currently paying on longer-dated US government bonds over 3% for the next 10, 20, 30 years.

So for equities to do better they need to produce a better risk-adjusted return than that – or promise that.

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SIMON BROWN: So why the disconnect this time, because, again, in the developed market we’ve seen the bond yields moving up to in many cases multi-decade highs? Yet, if we look at the equity market and appreciate it is maybe driven by a sort of AI/tech driver, certainly trading at or around highs we haven’t seen that normal sort of response from equity.

What is making it different this time?

JOHN STOPFORD: Well, I think the main difference is around future expectations of earnings. So, yes, people need now a higher return on their equities to justify owning them. But people are rationalising that by saying, well, I’m going to earn a lot more in terms of future revenues and future growth on the underlying businesses, and it’s going to more than compensate me for the high yield that I can now get on bonds.

So there’s an extrapolation, I think, of the recent past, and there’s a lot of hype about the kinds of earnings that we’ve seen in the short run being sustainable.

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That’s the big question for investors. Can companies that have delivered reasonable earnings of late, continue to do that ad infinitum? And are some of those earnings essentially overstated by the short-term cyclical boost from massive investment in AI-related capex? Is that sustainable in the long run?

At the moment, investors seem prepared to bet that that is the case, but a lot of people are questioning whether valuations now are just pricing in too much, and actually equity markets are becoming increasingly vulnerable – particularly if bond yields continue to rise.

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SIMON BROWN: I take the point around the vulnerability. And I also, as you’re responding there, it occurs to me that this is, that I’m looking for a single sort of trigger; but it happens over time.

It was in April last year that the US went through 5% for the first time – certainly in my investing life – and retraced and went higher again.

Is inflation one of the drivers? And then I’m going to say inflation, I’m going to say that oil at around the $100 to $110 a barrel – depending which blend we’re looking at – keeps inflation pressure on.

If we see yields starting to continue to rise, that puts extra pressure on equities.

JOHN STOPFORD: Yes, I think that’s right. I think inflation is part of it. Energy inflation works in two ways. It obviously pushes up prices, but also squeezes consumers’ ability to spend money on other things. They’re spending more on fuel and so on.

So it has a sort of double whammy. It pushes interest rates up, but it also squeezes people’s pocketbooks. I would say if you look beneath the surface, there’s definitely some tension. There are signs that higher bond yields and higher interest rates are crimping some parts of the market.

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So outside the AI or tech space, you’ve seen cyclical companies performing relatively poorly over recent months. Similarly, you’ve also seen a lot more pressure in the corporate bond market, not least because a lot of the big companies associated with AI – Google, Meta and so on – have been borrowing an awful lot of money to pay for all of these data centres.

So I would say the surface looks quite calm, looks quite benign. But if you look beneath the surface there are a few flags that I think might make people feel a little more cautious about whether higher bond yields are actually beginning to have more of an impact – and whether the future is quite so rosy.

SIMON BROWN: Because ultimately – and this is a very simplistic view on it – higher yields kind of beget higher yields because it means an extra ‘stay with the US for now’ as that ten-year grows up.

The US needs to borrow at a higher rate, which means it needs to borrow more, which means the rate goes up.

It is that feedback loop which we’ve been chatting about a couple of times on this show. So it is kind of almost in a sense self-fulfilling – which then says for the investor, where do they sit?

Does this just go back to the good old-fashioned ‘you need to be diversified’ because, if you’re not – particularly at this point – it starts to get a little bit spooky?

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JOHN STOPFORD: I think so. You’re right, borrowing costs are going up and that’s putting pressure on government deficits as well, and that makes their lives more problematic.

I would say, however, that typically these things happen over time. So even in the 1970s, when we saw a long period of high inflation, yields didn’t go from low single digits to high teens sort of overnight. It basically took 15 years.

Markets adapt. People learn through time. Bond yields might be on a journey higher, but in the short run they’ve risen a long way.

And so we’re starting, I think, to get to a point where there is meaningful at least short-term value in many government bond markets – and they do provide some diversification.

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As you say, if the AI bet turns out to be less of the sure thing than people currently seem to believe, yes, I think the diversification point is right. Certainly on a perspective basis at least you’re being paid a reasonable yield now, whereas if you look at the equity market you have to question whether the valuations imply decent returns and whether the earnings expectations are realistic.

SIMON BROWN: Yes, and I love your point. It plays out slowly. I know we want instant answers, but it plays out slowly and slowly is not weeks and months. Slowly is years and decades. It absolutely is.

John Stopford, head of multi-asset income at Ninety One, appreciate the time.

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