The slide in oil and other commodity prices has been key here but also the evidence pointing to a weakening economy is accumulating.
The fall in bond yields is not just a UK phenomenon. Much the same thing is happening in other major government bond markets, though to a lesser extent in the US Treasury market.
The evidence now indicates that the developed economies are heading into recession, if they are not in one already. Second quarter GDP growth in Japan and the eurozone has turned negative. In the US, GDP growth is being held up by the contribution from net exports. The growth of US domestic demand has already turned negative. Given that monetary policies are being geared increasingly towards restraint in the emerging economies and that growth has stalled in the major economies, the contribution to US GDP growth from net exports is set to become less supportive so US GDP is also likely to turn negative.
What all this means is that the downward pressure on government bond yields is likely to be sustained. Government bond markets not only reflect the growing conviction that the underlying tendency is disinflationary in the major economies but they also reflect just how deadlocked monetary policy has become.
In its Quarterly Inflation Report, the Bank of England judged the balance of risks to be on the downside for growth and on the upside for inflation, though ultimately it expects inflation to drop convincingly below target. The economy is in need of lower interest rates but inflation, which by the CPI is now more than double the MPC’s target and expected to climb further away from it, is preventing the MPC from bringing them down.
We have been making the point that lower gilt yields support the case for high yielding UK equities (see High yielders for value investors 16 July 2008 and A boost for high yielders in the UK equity market 6 August 2008). The chart on the preceding page conveys the sense in which high yielding equities have been moving. It shows the FTSE 100 along with the FTSE 100 excluding Resources. The latter is up some 11 percent from this year’s mid-July low. The FTSE 100 is up by half that amount.
The dividend yield on the FTSE 100 ex Resources got to be a full percentage point higher than that on the FTSE 100 in mid-July. It is less now but the index still carries a premium yield to the FTSE 100. It is dominated by the Banks but it has plenty of other high yielders in sectors like the General Retailers, Travel and Leisure, Household Goods, Media as well as few other financials. The FTSE 100 ex Resources has become something of a high yielding equities index.
A good test of whether the rebound from the mid-July low is just another bear market rally could come if and when oil prices (as well as other commodities prices) regain momentum, which could happen if China’s economy picks up steam once the Olympic Games are over.
Inflation in China has come down from a peak of 8.7 percent in February to 6.3 percent last month. In view of this deceleration, the Chinese authorities are now attaching priority to sustaining rapid growth and may choose not to tighten monetary policy further. They may even relax it.
But if bond yields continue to edge lower against this backdrop - on the view that the next move in interest rates is not only down but that there will more cuts thereafter - yields on UK equities should continue to fall. The equity market should be discounting recession already. The prospect of lower interest rates should not only help it to think ahead to the recovery but should also help high yielding equities acquire a re-rating. We think sterling is set to continue weakening and this will be helpful for earnings.
As the chart on the preceding page shows, the tram lines have defined a year long trading range for the FTSE 100 ex Resources. Having rebounded from its mid-July low, the FTSE 100 ex Resources has run up against resistance. At some stage, one or the other of the tram lines will be broken. The chances are it will be the top one - when interest rates are cut.