Interest rate rises test markets, but remember it is a long game

Australian bond yields (three-year bonds) have lifted towards 4 per cent as ASX dividend yields have pulled back to 4 per cent (pre-franking). S&P/ASX 200 dividend yields have not been matched by bond yields for more than a decade.

As yields (and cash flows) from bonds increase, asset allocators and investors consider re-allocating funds from equities towards bonds or fixed income securities.

However, the allocation between equities (growth) and bonds (income) is complicated by actual or predicted inflation and the anticipated level of economic growth. This is because economic growth supports equities over bonds. Inflation devalues the cash flow or yield from fixed income bonds, particularly if those yields are below actual inflation (known as negative real yields).

Over the past 18 months, interest rates have risen and chased inflation higher. Up to the end of September, in the face of rising interest rates, equity markets had performed reasonably well. The world index had risen by about 10 per cent in the nine months to September 30, driven by the heavy weighting to the US market (which has risen by about 12 per cent).

A disappointment has been the Australian market, seemingly dragged down by weakness in the Chinese economy and a devaluing Australian dollar. The Chinese equity market has pulled back given fears of financial issues across the property sector, but Chinese consumer demand has been resilient. Meanwhile, European markets have produced reasonable returns, and the Japanese market has been the star performer.

We must remember that the strength in the Japanese equity market follows decades of poor returns. The Japanese equity market has lifted even as its 10-year bond yields have risen from 0.5 per cent to 0.8 per cent over the past nine months. This is the clearest example that rising interest rates don’t always push equities lower – particularly when those interest rates are well below inflation.

Investors should always remember that investing is a long game that requires a constant eye to asset allocation – between growth and income assets. It also requires an acknowledgement of the volatility of returns that characterise the equity market. The equity market performance in October emphasises this point with 3 per cent to 5 per cent corrections across the world. In effect, the world equity indices have given up one PER point as long-dated bond yields rose by (on average) 0.5 per cent.

As for the future, in terms of predicting asset returns, it is always easier to predict the longer term (say five years) than it is to predict the next 12 months. That is because history for long-term asset returns is fairly stable. Equity returns will outperform bond returns over the long term because economic growth and inflation aids growth assets more than it does for income assets.

However, the next year will see the cash flow benefits of higher interest rates flowing to fixed income investors at rates not seen since before the GFC (14 years ago). As fixed income returns have become attractive, the relative attractiveness of equities is contested. So it is likely that fixed income returns will match and possibly exceed those of equities for the next 12 months at least.

Based on the last 10 years, it is clear that bond yields of 5 per cent are confronting, but they are still too low compared to inflation. Further, given the amount of government debt overhanging the markets, I believe that central banks will have no choice but to reintroduce quantitative easing to hold bond yields lower for their governments.