What does higher bond yields imply for equity markets?

Higher bond yields may mean stronger headwinds for equity beta but it also might be a boon for high-performing active managers, according to GSFM.

In a briefing to the media, GSFM investment strategist, Stephen Miller, said despite recent increases in yields, bond markets remained at close to historically low levels.

“More tellingly, the gap between the 10-year bond yield and annual core CPI inflation was close to 4% in December, the highest gap since February 1975,” he said.

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“And obviously, if we believe in some form of mean reversion, that might contract.”

Miller said the big question for 2022 was ‘how does the difference between current core inflation and the US 10-year bond yield resolve itself?’

“And I think that inevitably means higher yields,” he said.

But, according to Miller, “good active managers do well in times of market volatility, when equity beta, in the passive exchange traded fund (ETF) tsunami, is for the first time in a long time, facing some different challenges.”

Miller said some central bank governors ‘shrugged their shoulders’ in early 2021 and said monetary policy could not do anything in the face of a supply shock.

But, he said, central banks were beginning to learn that if supply shocks manifested in higher inflation expectations, purchasing behaviour would be affected.

“The notion of transitory inflation is that it doesn't feed into wage and price setting behaviour,” Miller said.

“If it does feed into wage and pricing behaviour, monetary policy does have a role to play in supply shocks, even if the initial judgement is that inflation is transitory, because it means to stop it getting into the inflation system, it needs to stop that vicious circle developing.”

While Miller conceded it was problematic to compare to situations in the past, the United States Federal Reserve did accommodate rising oil prices in the 70s following the effects of Vietnam war spending.

He said the Reserve Bank of Australia could do the same by removing emergency settings and adjusting rhetoric.

“And the benign scenario is that central banks act with alacrity and they lose the rhetoric that they employed for most of 2021,” Miller said.

“They get on top of the inflation problem, they get the market’s confidence that they're on top of the inflation problem, the increase in bond yields is contained, and we go back to a sort of benign period where markets have faith in central banks.”

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