Rising bond yields and shifting political dynamics are creating fresh challenges for investors. The multi-asset team at Keyridge Asset Management explains why in September they remained constructive on equities while keeping a close eye on inflation, government borrowing and market concentration.
Signals
The UK ten-year gilt yield is at an eighteen-year high. The US ten-year treasury yield is not there yet. Fingers are pointing at the new UK prime minister, who has generated plenty of noise, albeit little real action.
However, recent gilt moves have merely mirrored those in the US, suggesting a broader problem.
Recent weak attempts by the US Treasury to reduce its own long bond yield were poorly received by markets, with inevitably limited impact but attracting much criticism.
The Federal Reserve, with its new chairman, raised rates at the September meeting, which markets took as a sign of credibility and also independence from the White House.
However, the fundamental problems remain – global inflation is sticky and national budgets make uncomfortable reading. Long-term borrowing needs are rising, and investors need a reward for uncertainty.
To us, the investment risks are inflation, and future supply based, rather than relating to risk of default.
In this respect, Germany is the outlier among major Western economies, with far lower public debt and more balance-sheet capacity than peers. However, it has problems of its own. It has lost access to cheap Russian gas, replaced instead with a powerful and hostile neighbour.
Its once-mighty auto industry is struggling against Chinese competition, and Germany has underinvested in digital infrastructure.
Recent gains by the hard-right AfD party reflect Germany’s economic difficulties. French politics is moving in a similar direction too, with the hard-right National Rally polling very strongly for both parliamentary and presidential votes.
Higher gilt yields raise the non-trivial chance of an early UK election too, which would likely see strong gains by Reform, but if won, would legitimise the new prime minister’s new and likely costly socialist agenda.
This would be a risky move – the government majority is large but built on many very slim majorities.
Equity markets continue to absorb the moves in bond markets remarkably well. Earnings momentum remains strong. Breadth is holding up, even with underlying rotation. Share prices of the ‘Mag Seven’ are holding up but are no longer leading the pack.
The AI infrastructure beneficiaries seem to us better placed than the model developers. We are baffled by the enormous private valuations of the frontier AI model developers, given their exorbitant cost and the short lead time they command on cheap Chinese models.
However, semiconductors, power, networks, and data centres still have real demand.
Despite the political risk, European equities are cheaper, banks are profitable and the earnings base is less dependent on a handful of technology companies.
Strategy
Our broad message is not risk-off, more that the cost of capital is slowly reasserting itself. We remain constructive on equities, but selective, continuing to favour areas with visible cashflows and real pricing power.
These include banks, infrastructure, industrials, power and the less crowded parts of the AI capital-spending chain.
Within equities, diversification matters more than formerly. The concentrated US market is vulnerable to disappointment in AI returns. Europe, Japan, equal-weighted baskets, and selected emerging markets offer useful alternatives.
We are still wary of long-duration government bonds; UK gilts now offer more yield, but they also carry more volatility. We see a breakout in yields as bearish.
We also prefer shorter duration and flexibility; gilt yields peaked above twelve percent in 1990 and then fell for 30 years, before bottoming in 2020 at 0%. This is a reminder that yields can move a long way and trend changes can take a long time.
Recent economic and political developments do not, in our view, signal such a change.
Gold continues to protect against fiscal profligacy, currency debasement and attempts to suppress bond yields.
If US treasury yields do break out, the signal becomes global. Until then, the UK move looks more domestic than systemic. We should respect it, not extrapolate it.
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