Aside from rock solid institutional demand for index-linked stocks, these ‘absolute return’ type vehicles have been beneficiaries of that deadly duo restraining the global economy - the credit squeeze and the rise in oil prices.
More recently though, index-linked stocks have lost momentum and, as the chart shows, the conventional side of the gilt market has picked up. This may reflect nothing more than a correction for valuation or a technical adjustment. Breakeven inflation rates reached the highs not seen since the mid 1990s, thus leaving the index-linked market a little overbought.
The loss of relative momentum behind the index-linked market is noteworthy for its timing, having coincided more or less with the start of the sell-off in the oil market back in July.
It is worth keeping an eye on the gilt market. It could be providing a lead on two things. First, aside from any technical adjustment, if the shift in relative momentum towards the conventional side of the market continues, this may be signalling an eventual revision of inflation expectations and a turn in headline inflation itself. That is, it might be discounting recession, disinflation and the prospect of lower interest rates. Yields on short dated conventionals have dropped below Bank rate again.
Second, if the gilt market is beginning to discount the prospect of lower interest rates, the equity market is likely to be doing so too. As discussed in a recent note (High yielders for value investors, 16 July 2008), the UK equity market, ex resources, is discounting plenty of bad news and pockets of value exist. That note focused on high yielding equities - shares with a premium dividend yield to the market average - and drew attention to a number of such shares where the risk of a dividend cut was judged by us to be negligible. The table containing those shares is reproduced on the next page along with performances in both absolute and relative terms from the market’s mid-July low as well as over one, three and twelve months.
There is a lot of blue in the table. Most of the shares have moved well and are outperforming the market. They are not the only shares doing so - there isn’t a bank among them - but if you look at the top ten performing sectors in the UK equity market since the mid July low, six of them offer above average dividend yields. High yielders have made a good start in the right direction and there are plenty more about.
If conventionals continue to outperform ‘linkers’, or indeed, if yields just continue to fall, the message from the gilt market would seem to be that the next move in Bank rate is down, that recession and disinflation lie ahead, even though there are price increases (e.g., the latest utility price rises) which have yet to come through to headline inflation. Lower gilt yields should bring stability to high yielding equities and that could be the first step towards their eventual re-rating.
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