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Are rising yields a reason to panic?

US government bonds have been under pressure since the beginning of the year. The 10-year Treasury yield has risen to 2.62%. Since then, investors have been spooked by one question: has the bond bull market come to an end and will higher yields derail the equity market? Over the course of the year, US Treasury yields could still rise to 3%, but this is hardly a bear market and certainly not a sell-off.

Rising yields have the potential to hurt equities, but only under certain conditions.

If the rise in yields is reflecting worrying economic conditions:

  1. Lack of growth: This is far from the case at present as robust global growth is likely to continue in 2018. The tax reform in the US has the potential to further boost the recovery. The central banks also do not expect any unpleasant surprises for the markets: interest rate hikes have been widely announced and are now factored in. The ECB could announce higher rates only towards the end of the year.

  2. Rising inflation: Inflation will remain weak in 2018. Currently, inflation is driven mainly by rising oil prices. Although unemployment worldwide is below the long-term average, wages continue to underperform. Behind this is a change in the structure of the labor market: in Japan, as a possible precursor for developments in Europe and the USA, the proportion of full-time jobs has declined in recent years, while the number of part-time employees has risen steadily. At the same time, the share of typically lower-paid jobs in the service sector, has increased. Jobs with higher wages, such as in the processing industry, have become scarcer. However, a rise in productivity is a probability this year which ultimately leads to a higher wage inflation in 2019. Increased investment by companies, is likely to boost productivity in the coming quarters.

If the rise is making it harder for companies or consumers to borrow.

So far, this is not the case either. Financial conditions are the easiest they have been since the mid-1970s. Capital markets are awash with liquidity and always on the look-out for investments. This is good news for borrowers as can be seen in the declining default rates. Consumer sentiment is picking up, residential real estate is once again on the upswing.

If higher yields start making equities look unattractive by comparison.

Yields will need to rise much further before this is the case. The equity risk premium, a measure of equity attractiveness relative to real bond yields, stands at around 5%, compared with an average of 3.2% since 1960. Even if we look at dividend yields, many top companies pay out more than US Treasuries. A drop in equity valuations would make dividend yields even more attractive and a reduction of the dividend is not on the cards as the overall economic backdrop is very positive.

While strong economic growth could hurt bonds, it is a plus for corporates and the equity markets. The earnings season that is just beginning will be a case in point.

Stay put and if you have any questions or comment, please let us know

Switzerland, January 31st, 2018

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