Why bond yields could signal a buying opportunity in stocks

We’re looking to bonds for further clues on what the market might do, and also how to take advantage of the current high yields.

As we deal with the fallout of another month where volatile trading conditions have rocked the market, it is an opportune time for us to review our thesis around where we see the market heading.

Inflation, something that we recently covered in detail, is in our view likely to come down sooner than many observers in the market would expect.

To date, we see inflation as having peaked, or at least near its peak, with core inflation figures already trending in the right direction over several months. With commodity prices now starting to deflate at a rate of knots, we can begin turning our attention towards bond yields.

And on this front, it is our view that bond yields have not only risen too quickly, but they have also overshot to the upside.

Bond prices tend to fall when interest rates rise, which translates into rising yields. The US 10-year Treasury Yield hit as high as 3.5% in mid-June, but since then, it has traded as low as 2.78% in recent days as traders readjust their forward views of interest rates.

Central bank ‘shocks’ sufficient to combat inflation

We’ll start with our belief that the US Federal Reserve, and a number of other central banks as well, have made the right move to rein in inflation by ‘shocking’ the market with aggressive rate hikes.

This hasn’t been without impact. We have witnessed a hit to consumer sentiment given the size and pace at which rates have increased, something not seen in decades.

However, central banks cannot sit idly by and let inflation run its course for too long, otherwise it will become increasingly harder to put downward pressure on prices.

With this in mind, and the outlook for several more aggressive rate hikes to follow over the coming months, we see inflation as being largely ‘under control’, and interest rates being unlikely to go as high as some analysts predict.

Yes, inflationary pressure could still persist for some time at these elevated levels, but with the exception of Australia, which is largely 6-9 months behind the rest of the world, our base case does not see inflation accelerating from this point.

As we said, if anything, inflation has started to show some signs of moderating, at least when measured through a ‘core’ basket of goods.

With central banks now becoming clearer and more decisive with their forward messaging, there is more transparency for investors, consumers, and businesses alike.

As the shock of the current rate hike cycle wears off, and we see rates reach a more manageable ‘peak’ that provides for some stability, we expect to see consumer spending, business investment, and growth return to the fore. In turn, this would support our view for equity price growth in the mid-term.

Commodities are also coming off the boil

With commodities being one of the major drivers contributing to inflationary pressure in 2022, recent selling pressure across a broad basket of commodities is another factor that suggests inflation may have peaked.

From iron ore, to copper, agriculture goods, and more recently, oil, the heat has been taken out of the prices of a number of commodities, and it will only help combat inflation.

The irony isn't lost on us. Downward moves in the prices of these commodities have for the most part been triggered by concerns about slowing economic growth, and the prospect of a recession.

However, that is why the US Federal Reserve, as well as other central banks, have the delicate task of trying to deliver a soft landing.

There is also the possibility commodity prices turn around again and trend higher, but we see recent interest rate hikes, and those to follow doing enough to keep demand in check.

Further room to fall?

In the short-term, we anticipate there may be further shocks for the global economy, as well as the stock market at large.

Perhaps the biggest risk emerging on the horizon is the upcoming earnings season, both in the US, and at home as well.

But we are also cognisant of the amount of selling that has already taken place. In the US, markets are still substantially off their highs, so we feel much of this has been priced in, and where it hasn’t, the downside appears relatively modest.

More recently, the ASX has also started to consolidate some margin off its highs. Weaker commodity prices, and a concern about the property market have had a pronounced effect given the sector weighting of our market.

But again, these sell-offs are more reflective of an expected downturn in the economy, whereas the miners and banks are still earning substantial profits and trading at low valuations.

What’s more, while we acknowledge the housing market is likely to face pricing pressures in the short-to-mid-term, we do not see a GFC-type event as long as employment remains strong. In turn, this should provide a cushion for the ASX, and to a lesser extent, the US stock market.

The extent of the sell-off, largely in lieu of any ‘tangible’ confirmation around sluggish economic growth or contracting earnings, is central to our view that now is a buying opportunity for astute long-term investors.

It is impossible to pick the bottom in the market, or the top for that matter. But if you apply a long-term view, circa 3-5 years, we believe the current situation is a wonderful opportunity to add quality stocks.

Not only do we see capital appreciation on offer during the coming years, but we also see some of the market’s biggest names maintaining attractive yields, underpinned by robust operational performances.

Leveraging bonds as an investment

While our base case makes the argument that inflation is currently ‘under control’, insofar as no longer getting away from central banks, and likely having peaked, we do recognise the risk to this scenario.

If inflation does persist for several more months, and we see bond yields continue to climb higher on expectations central banks will hike rates for longer, we will be looking at picking up bonds as a short-term investment.

During June, this was an investment strategy we began to implement in our flagship Hub24 superannuation portfolios. Bonds have been trading with very attractive yields that make them appealing on a relative basis, both from an income perspective, and on their face value.

Nonetheless, we recognise that this is an ancillary, short-term strategy. We believe that once inflation does start to show more concrete signs of trending lower - something aided by falling commodity prices - the market will begin to price in a lower ‘neutral’ level for interest rates, or even rate cuts after the current cycle, and this should prompt growth in equity prices.

Download The Full Report Below;

Monthly Update July 2022 - Kauri
Download PDF • 1.33MB

0 views0 comments