Bond yield rise a vote of confidence

Investors have enjoyed several years of outperformance in high yield and defensive stocks benefiting from their relative appeal to falling long term government bonds yields. Think property trusts, utilities and some industrials. These are now being sold down as the marginal dollar shifts either: a) back into bonds, for their improving returns, or b) into cyclical laggards leveraged to higher economic growth such as commodity stocks and cyclical industrials. Notable industrial performers include difficult-to-forecast cyclicals in chemicals, manufacturing and insurance providing a headache for investors as they offer far less earnings certainty than defensives. 

Has the market got ahead of itself? On our preliminary analysis, Trump’s economic plan would add 0.4pc to US growth, both in 2018 and 2019 which is clearly positive for corporate earnings and share prices. However we think the market’s relative moves since the election are overdone, given risks attached to the legislative passage, financing, execution and impact of Trump’s plan and the fact that its full effect wouldn’t be felt until 2018-19. Our Research Sector specialists can form sensible arguments showing that high yield, defensive stocks are now oversold (too cheap) and that some commodities and cyclicals are overbought (too expensive), as they are similarly discounting risks to a recovery. This isn’t the first, nor will it be the last time that markets overshoot fundamentals. 

The ongoing recovery of cyclical industrials in line with a reflationary economy is a theme that we expect to continue to play out in coming years. However progress is likely to be slow, and interspersed with periods where the markets may lose or gain confidence in the timing of its trajectory, not to mention likely macro shocks. Similarly, we expect interest rate settings to remain at historically low levels providing investors opportunities to accumulate high yielders which get oversold in the market over exuberance. 

We have consistently flagged that the path to the normalisation of global monetary policy is going to be slow and bumpy. It’s paramount that investors appreciate that after years of debate around the trajectory of interest rates that the economic environment has now begun to shift. Therefore equity sector allocations that performed best in the past five years are unlikely to be those that deliver outperformance in the years ahead. Investors need to adapt with the market.