Shares can weather bond turmoil

What a difference a month makes to markets. The year started with the predicted run-up in shares, led by a buoyant mixture of green economy hopes, technology leaders and companies likely to benefit from post-pandemic recovery.

I reduced my exposure to the Nasdaq index of tech stocks ahead of this year, expecting some rotation out of the great winners from lockdown such as Apple and Netflix. I wanted a broader spread with more exposure to general economy recovery through world and country indices. 

But gains in markets in the year’s opening weeks were hit by a sell-off in the second half of February, as investors recoiled from some extreme rises and high valuations, and took profits on Nasdaq and other winning markets. The FT fund put on around 5 per cent in the first few weeks of 2021 and lost most of that in the sell-off.

However, there were bigger fears circulating than concerns about tech or over the extraordinary surges in highly speculative bets such as bitcoin. 

What really spooked investors was the return of the bond vigilantes, who used to worry governments and force interest rates up in times of higher inflation. They suddenly reappeared and took on today’s very accommodating central banks. 

One certainty of the post-pandemic recovery was rapidly questioned. Most investors had assumed that yields would stay ultra low for another year, with the main central banks creating as much money as it took to keep rates down, so that large economy-boosting borrowing by governments would remain cheap. 

Instead we saw yields on longer-dated government bonds rise. There were conflicting explanations.

Some thought inflation might rise further and faster than planned, forcing central banks into earlier action to control price rises by pushing rates up.

Others argued that on current trajectories central banks would still fall short of their targets and needed to be pushed into taking more action. They want more bond-buying to stabilise yields and keep them low.

It’s likely some upwards move in inflation and a modest rise in longer bond yields should be compatible with good share price performance in the early stages of a vigorous economic recovery. 

After all it means companies will have more pricing power and will undertake more business activity, which should lead to better profits, dividends and shareholder value. Bond market weakness can be seen as confirmation that recovery is coming. Few think official short-term interest rates are going to rise on either side of the Atlantic any time soon.

The aim of the Biden administration is to run the US economy hot. The Treasury Secretary thinks the US needs both a large fiscal stimulus and a large monetary injection to get back to something like full employment. The Federal Reserve says it will cut the government some slack, agreeing there are downside risks and plenty of spare capacity. The Fed wants to run with inflation a bit above 2 per cent for a period to make up for the long undershoot. The Fed needs to show they are sufficiently in charge of markets to allow them to run as hot for a while. There is little point in boosting the budget deficit with more stimulus if borrowing rates are driven up in response to offset the advantages of the spending support.

There has also been a modest rise in bond yields in Japan, the eurozone and the UK even though these economies are not announcing big new stimulus measures on top of previously-announced anti-pandemic spending.

Expectations that official short rates will stay low persist and inflation forecasts are still at acceptable levels despite the market forcing interest rates on longer bonds up. Yields on 10-year US Treasuries rose to 1.5 per cent, from a low of 0.5 per cent last August.

The US authorities have the firepower to stabilise things and to reassure markets about their recovery strategy. It still feels like a reasonable backdrop for share investment, with opportunities in a wider range of sectors and geographical areas as recovery spreads. 

Governments cannot allow economies to run too fast indefinitely because they will risk overheating, but they do need to get recovery going before slowing things down

The FT fund therefore now has more in general market index funds which can help capture this mood. Individual shares and sectors get overblown from time to time, as there is so much money chasing good stories. We see some of the excess liquidity drive the price of anything with an exciting story to stretched highs, only to be followed by a sharp recoil when the mood temporarily shifts. The pound has also been a beneficiary this year so far, with more global investors interested in the good recovery prospects. The US dollar index-linked bonds in the fund are hedged back into sterling.

As clean energy soared I took some profits on what had become a large position. The strong short-term performance had taken the fund above the 60 per cent limit set for stocks as opposed to bonds, so equity holdings needed to be reduced.

BP joined the green energy buying boom and paid very high prices for wind farm blocks in the Irish Sea, leading people to ask if it was all getting a bit overdone. BP said it could still achieve potential returns on investment of 8 per cent or so. But the company’s critics worry about the costs, even when the long-term case for green investments remains strong.

Governments cannot allow economies to run too fast indefinitely because they will risk overheating, but they do need to get recovery going before slowing things down.

There are plenty of difficulties to work through. Companies need capital reconstructions after long periods of little or no trading with big debt build-ups; and businesses such as high street retailers face structural challenges, notably the fierce attack from online rivals. 

We don’t yet have a clear view of how much office accommodation will be needed in the future, or how popular homeworking will remain and how long it may last.

We are still some way off a return to the prompt paying of rents on many shops or a sustainable new level of payments. The green revolution will produce more green jobs but it also challenges the future of many car plants, power stations and traditional manufacturers.

These sectors need plenty of economic stimulus to sustain them. I have been running the bond portion of the fund with a high proportion in cash while we wait to see where longer-term bond rates end up. But I am sticking with shares to enjoy more of the coming recovery while keeping a careful eye on shifting market moods.

Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. john.redwood@ft.com