ARE EQUITY MARKETS TOO OPTIMISTIC OR IS THE VIEW OF BOND INVESTORS TOO BLEAK?

ARE EQUITY MARKETS TOO OPTIMISTIC OR IS THE VIEW OF BOND INVESTORS TOO BLEAK?

This week has seen more optimism in equity markets, while bond investors continue to take a more gloomy view. In the US, negotiations over the debt ceiling appear to be making some progress and this helped the positive sentiment towards US equities. However, bond markets remain far more sceptical. The potential for default has pushed yields on the shortest Treasury Bills to their highest level since the financial crisis, while the yields on longer-dated bonds show investors expect the Federal Reserve to cut rates as the economy deteriorates.

A disconnect between equities and bonds can been seen in other markets. Japanese equities have been rising steadily in 2023, but bonds remain more cautious. Meanwhile, UK equities have risen strongly since the dip in mid-March and the FTSE is one of the better performing indices this year. However, bonds have taken a leg down as the Bank of England signals it may continue hiking rates. Consensus often contributes to complacency in financial markets, and widespread agreement raises the possibility of a major shock, but both markets cannot be correct.

UK: BANK OF ENGLAND SAYS WAGE PRICE SPIRAL HAS TAKEN HOLD

Bank of England governor Andrew Bailey warned the UK is already experiencing secondary inflation effects as higher prices caused by supply chain disruption and high energy costs have given way to price increases caused by employers needing to cover higher wage costs. The latest UK employment data shows the jobs market remains robust. The employment rate has ticked up slightly as some people who chose to stop working during the Covid pandemic return to employment. Wages continue to rise at a much faster rate than in recent years, as average private sector wages increased by 7%.

Last week, the Bank of England raised its forecast for inflation. It now expects inflation to remain above 5% this year and not to return to target until 2025. Andrew Bailey’s comments this week opened the way for further rate hikes as he promised the bank would raise rates as far as necessary to get inflation back to target. His comments contributed to a decline in gilts as the yield on 10-year UK government bonds rose to the highest level this year.

PROPERTY: LANDLORDS SEE THE BOTTOM FOR TUMBLING OFFICE VALUES

Some of the UK’s biggest commercial landlords have been setting out the damage caused by soaring interest rates. Land Securities and British Land said their central London offices have fallen in value by 8% and 12% respectively over the past year as higher rates and the rise of working from home has combined to dent valuations and reduce demand. Last month, Segro reported the continued decline in the value of its industrial properties, although it said a shortage of supply is supporting rental income.

However, Land Securities and British Land say demand for prime central London offices remains strong and report rising rental income. With the Bank of England expected to soon stop hiking interest rates, British Land chief executive Simon Carter expects central London property values to stop falling. Commercial landlords are also hoping to see demand for office space continue to rise as employers encourage people to spend less time working from home, although older buildings with poor energy efficiency are likely to remain unpopular.

JAPAN: EQUITIES GAIN AS ECONOMY GROWS QUICKER THAN EXPECTED

Japanese equities have risen to levels not seen since the early 1990s as the drop in the yen and improving corporate governance attract investors. The broad Topix index and the larger companies Nikkei 225 index have risen strongly, with the Topix up around 14% in the last 12 months. The effect of currency exchange means UK investors have gained around 7.5%, but this is second only to Europe over the last year.

Japan is also experiencing stronger economic growth. GDP rose by 0.4% in the first quarter of the year, and annual growth is now around 1.5%. This compares to the forecast of -0.2% for the UK. The Japanese economy has benefited from stronger consumer spending following the removal of Covid restrictions. Japan does face some headwinds as the government is expected to begin reversing the huge fiscal stimulus programme and decades of ultra-low interest rates, and this could see the yen appreciate. It’s strong trade links with China mean exports could weaken if Chinese growth falters.