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The bond selloff is likely to have lasting effects on stocks

A surge in bond yields has interrupted the 2023 stock rally, leaving investors sifting through market signals to predict what comes next.

Stock investors are scrutinizing the bond market because yields affect everything in markets and the economy, from corporate borrowing costs to the present value of future earnings and the likely direction of stock indexes.

That means the bond selloff, which recently drove the yield on the benchmark 10-year Treasury note above 4.8% for the first time since 2007, could have lasting effects on which stocks lead the market and when major indexes start climbing again.

The S&P 500 has retreated 5.5% from its July high, cutting its year-to-date advance to 13%, while the Dow Jones Industrial Average briefly gave up all of its gains for the year last week.

Analysts say the size and speed of the changes in long-term rates make it less likely that stocks are poised to embark on a sustainable new rally.

“Rates are really the name of the game right now,” said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions. “As long as you have that upward pressure on rates, that’s what’s really keeping the equity markets in this kind of stasis.”

The swift climb in yields has eroded one measure of the reward for holding stocks over government bonds—known as the equity-risk premium—to its lowest level in more than 20 years.

The S&P 500’s earnings yield, based on profits expected over the next 12 months, was just 0.766 percentage point higher Friday than the yield on the 10-year Treasury. That’s the lowest equity-risk premium since June 2002, according to Dow Jones Market Data.

The dwindling reward for risk-taking has weighed on prices throughout the stock market. Several commonly used technical indicators show the extent of the pullback.

The number of S&P 500 stocks hitting new intraday 52-week lows recently rose to the highest level since October 2022, while the share of stocks trading above their 50-day moving averages fell to its lowest level in a year, according to Dow Jones Market Data.

In June and July, as the index advanced toward its 2023 high, few stocks were making new lows and many were trading above their recent averages.

The low levels of the breadth metrics don’t mean the market has bottomed. But when the indicators start to improve, that can be a promising signal, said David Keller, chief market strategist at StockCharts.com.

The S&P 500 as a whole, meantime, has fallen close to its 200-day moving average, a long-term trend line consulted by analysts. It ended Monday 3% above the moving average. One day last week, it closed just 0.7% above the line.

“Holding the 200 day is one of those basic measures of: ‘Is this market holding up or is it potentially getting a lot worse?’” Keller said.

Falling below the moving average shows “there aren’t buyers coming in where you’d expect they normally would, and that usually is a concerning sign of a further bearish decline,” he said.

The S&P 500 rallied Friday, notching its best day in more than a month, after investors cheered signs of softening wage growth in the September jobs report. Technology stocks led the way higher, again powering the market after a recent spell of weakness. Investors are also watching the unfolding Israel-Hamas war for developments that could affect markets.

Rising interest rates hold the potential to spur a more lasting shift in market leadership. The low rates of recent years made the future growth promised by tech companies particularly attractive. If rates were to remain high, that could make far-off profits a less alluring bet.

So far, the tech trade hasn’t suffered much. A handful of large companies in technology and adjacent sectors account for most of the S&P 500’s advance so far this year. Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia and Tesla make up 30.5% of the S&P 500, up from 21.5% at the end of last year.

In one sign of how the index’s large stocks are leaping ahead, the S&P 500 is on pace this year to outperform a version in which each constituent is equally weighted, rather than weighted by market value, by the most since 1998.

Utilities, consumer staples and real-estate stocks have slumped lately as higher yields make their sizable dividend payments less enticing.

Value stocks, traditionally considered those that trade at a low multiple of their book value, or net worth, also have lagged behind the market. Some investors expect that dynamic to reverse if rates remain elevated, since the prices of such shares tend to be less reliant on expectations of robust growth.

“You would own U.S. small cap and value stocks in that higher-interest-rate environment, as opposed to the large megacaps,” said Rick Pitcairn, chief global strategist of multifamily office Pitcairn. Instead, “nobody wants them.”

That might be because many of those stocks are seen as vulnerable to any economic downturn. But Pitcairn expects higher interest rates to persist long past the next recession, making small-cap and value shares attractive investments in the coming years.

The rise in yields has prompted some investors to question the lofty valuations commanded by some corners of the stock market. The technology sector traded last week at 24.9 times its projected earnings over the next 12 months, above a 10-year average of 18.6. The S&P 500 as a whole was priced at 18 times future earnings, slightly above its 10-year average.

Those valuation measures are based on forecasts for strong earnings growth. Wall Street expects corporate profits to take off next year, growing 8.2% in the first quarter of 2024, 12% in the second quarter and almost 14% in the third quarter, according to FactSet.

Some money managers are skeptical. Many expect that the tightening of financial conditions caused by the Federal Reserve’s interest-rate increases is still working to slow the economy.

“How does the economy reaccelerate and earnings reaccelerate alongside that with that macroeconomic backdrop? I just don’t see it,” said Matt Stucky, vice president and chief equity portfolio manager for Northwestern Mutual Wealth Management.

Sunak’s decision to curtail the rail project goes against international experience

Imagine you were connecting two cities, one rich, one poor, separated by a wide river. A transformational plan for a new bridge is forged to improve connectivity between them and stimulate growth. Evaluations suggest the long-run benefits far exceed the upfront costs. But high upfront costs, and distant long-run benefits, are hostages to short-term thinking. To save money, the decision is made to build only half a bridge, starting from the rich side of the river.

Not unreasonably, people soon question the value of this half-bridge. And, having started on the expensive side of the river, not only are upfront costs higher than planned but the benefits have disappeared entirely. A quarter of the way in, cost-benefit calculations are rerun. They suggest even completing the second quarter of the half-bridge is now uneconomic. That is duly canned and blushes are covered by using the cost savings to finance hundreds of small boats for use by those on the poorer side of the river.

This, alas, is no fairy tale. It is the grim story of the UK’s High Speed 2 rail project. Last week, Prime Minister Rishi Sunak announced this would be a quarter-bridge (London to Birmingham) rather than the half-bridge (London to Manchester) promised, with the savings reinvested in small local transport projects. This decision, and the many leading up to it, are a case study in how not to evaluate, design and deliver long-term, transformational growth projects.

It is easy to forget that HS2 began life as a full bridge. It was intended not only to connect the great cities of the North, including Manchester and Leeds, but Glasgow and Edinburgh in Scotland. Today, people talk animatedly about “15-minute cities”. At its inception, a completed HS2 would have made the UK a “90-minute nation”. Its major cities would have been connected in the time it takes to watch a football match, well ahead of many competitors.

The calculus of this expansive plan were clear and compelling, some pointing to £2.40 of benefits for every £1 spent. And even this was a potentially significant understatement. The Treasury’s project evaluation framework is designed for small projects yielding static, linear returns. For large, transformational investment projects where the network benefits are dynamic, the framework misses most of them.

International experience is salutary. Much is made of the rise of the global megacity. But it is mega-regions — connected agglomerations of megacities — that are the new frontier of growth. What started in the Tōkaidō region of Japan in the 1960s is now a global phenomenon. China has about 20 actual or emergent mega-regions, the US about a dozen. Each is part of a strategic economic development framework, underpinned by an inter-city connectivity plan. More than 25 countries have created or are building high-speed rail networks to unlock the economic potential of emergent mega-regions.

All, that is, except the UK. Instead, the full HS2 bridge has been thin-sliced into the world’s most expensive pier. With each curtailment, the network benefits have beaten a hasty retreat, and with them the prospects of the UK becoming a high-growth, high-connectivity mega-region. The country’s great cities will remain connected, but in the time it takes to watch a cricket Test match.

This outcome is all the more surprising because most analyses suggest the aggregative potential of the UK is very high given its twin endowments of large existing regional imbalances and small geographic footprint. The OECD ranks the UK, along with South Korea, as having the highest degree of potential mega-region centrality, as measured by access to population by distance and possible travel time. HS2 decisions mean the UK’s growth is unlikely to be travelling at high speed any time soon.  

None of this is to suggest it is unwise to invest in smaller, local transport projects. Lack of investment here is one of the reasons the UK’s great cities underperform their international peers. The mega, or 15-minute, city should indeed be the aspiration. But it is a false trade-off to see this is an alternative to improved inter-city connectivity and a potential 90-minute nation. As international experience makes clear, the journey from city to megacity to mega-region is an up-only growth accelerator.

Like many of its citizens, this is not now a journey the UK will be making rapidly. Rightly, Sunak last week implored us to think big, bright and long-term. Decades of decision-making around HS2 could scarcely stand in sharper contrast. If it continues to underinvest in long-term transformational projects, few things could be dimmer than the UK’s own growth prospects.

UK private equity firms sell assets to themselves as exit routes dwindle

Disposal of portfolio companies to ‘continuation’ funds becomes preferred strategy to return cash to investors

UK private equity managers now see selling companies to themselves as their best option to offload investments, according to new research, as a moribund IPO market and the higher cost of financing deals make traditional exit routes more difficult. 

Disposals to so-called continuation funds are the most popular option for private equity executives seeking an exit from their investments, according to a poll of 200 senior UK-based industry professionals carried out by Numis. 

The results, due to be published this week, underline the rising trend of private equity funds turning to newer funds raised by the same firm as they seek to sell their assets to return cash to investors. 

Private auctions, the preferred route in last year’s poll, are now the least popular of four exit options as a more difficult debt financing environment combines with political uncertainty ahead of UK and US elections.

The gloomy economic outlook and the gap between buyers’ and sellers’ valuations were also cited among the most common barriers to dealmaking. In Europe, the number of sales from one private equity firm to another dropped earlier this year to the lowest level since the Covid-19 pandemic.

The vast majority of those polled, drawn from professionals focused on mid-market deals worth £500mn-£1bn, did not expect a fully functioning initial public offering market before the final quarter of 2024. 

Despite this, IPOs were ranked as the third most popular option for prospective disposals while a “dual track” process, where companies prepare a stock market listing and a private sale in parallel to keep options open, was second. 

The growing use of continuation funds has attracted scrutiny with the chief investment officer of asset manager Amundi last year likening parts of the private equity industry to a “Ponzi scheme” that would face a reckoning in the coming years. 

The technique involves a private equity fund selling an asset it has owned for several years from one of its funds where investors have been promised a return in cash to a newer fund where backers are not due to get their money back for a few years. 

The popularity of the strategy has grown as pulling off deals has become more difficult. Global dealmaking fell to a 10-year low in the first nine months of 2023. 

Supporters of the method say flipping assets from one fund to another can allow private equity firms to continue benefiting from assets with strong cash flow. 

While the new fund may have different backers, or may invest alongside third parties, the method raises questions around how a private equity firm should objectively value an asset while doing the best for the investors in both funds. 

The UK’s Financial Conduct Authority said this month it was planning a review of the valuations of private assets, warning that higher interest rates were likely to result in lower valuations and could present risks to the financial system. 

The survey found that, for UK assets, private equity sponsors have shifted their focus from public companies to private companies. 

The poll found 71 per cent of executives were focused mainly on targeting UK private companies, up from 11 per cent a year ago. The proportion focusing on UK public assets plunged from 73 per cent to 14 per cent. 

The change in focus came despite respondents’ view that private assets were more likely to be overvalued than public companies. 

Numis said the findings reflected “a perception that public investors may be less willing to sell currently, making it harder to execute these deals, and that there is a wider opportunity set in UK private markets”. 

For the survey respondents, who were based in London but invest globally, the UK has greater appeal than other markets, Numis found, with 85 per cent saying the country was more attractive than the other markets where they invest. 

Large companies hold off committing to real estate deals as working patterns remain in flux

Demand for office space has slumped further, with vacancies reaching at least 20-year highs in the US and London, as people continue to work from home despite companies’ attempts to get staff back in the office after the Covid-19 pandemic.

Vacancy rates have risen to fresh highs and investment in offices fell sharply in the third quarter this year compared with the same period in 2022 in London, New York and San Francisco, according to preliminary data from CoStar, a research company focused on commercial real estate.

The sustained slowdown in the office market comes as higher borrowing costs and low occupancy are compressing building valuations while companies including Amazon, BlackRock, Lloyds Banking Group and JPMorgan have in recent months introduced staff attendance mandates on given days.

“The big ticket transactions [are] really not happening at the moment,” said Mark Stansfield, director of UK analytics at CoStar. “There is still a divide of expectations between sellers and buyers.”

Jonathan Gardiner, head of real estate agent Savills’ central London office agency, said large companies were holding off pulling the trigger on real estate deals because they were “still trying to understand their spatial needs” as working patterns shift from Covid-induced work from home to hybrid working and an increase in mandated office attendance.

Vacancies in San Francisco offices hit a two-decade high and reached a 20 per cent rate in the third quarter — up from 6.3 per cent at the onset of the pandemic. The Californian tech hub only generated £454mn worth of investment in office space in the period, less than a third of its pre-pandemic average.

“Places like San Francisco have been hit particularly hard given the level of hybrid working and levels of tech occupation over there,” said Stansfield. Tech workers have embraced remote working more than other office workers, according to analysts.

Investment in London rebounded slightly to £2bn in the third quarter thanks to a flurry of deals in the City fuelled by appetite for green, modern and newly refurbished offices in central London which are in short supply. However, it remains far below its pre-pandemic levels and more than a fifth lower year on year.

The tech and media sectors historically boosted London’s office take up, but companies in those industries are shedding space as they experience slower growth, said Gardiner. London’s vacancy rate hit 9 per cent in the third quarter, the highest since CoStar started recording the data in 2003.

The picture in New York was similarly grim in the third quarter, according to CoStar data. Investment in the city’s offices fell by 60 per cent on the previous quarter while its vacancy rate remained at 13.4 per cent, hovering near a two-decade high.

In a positive sign for the commercial real estate sector, leasing showed signs of renewed activity in the third quarter. Large deals in London’s City and West End drove a 19 per cent quarterly jump in leasing activity in the UK. In the US, leasing activity rose by 13 per cent overall despite falling in San Francisco.

China’s Golden Week offers economic bump but property ills persist

Policymakers urged to take stronger action to boost growth as tourists spend less on luxury goods and services

China’s Golden Week holiday provided some relief for the world’s second-largest economy as it struggles to recover from the coronavirus pandemic but policymakers will have to take action to spur stronger growth, economists say.

Domestic tourism numbers and revenue during the eight-day holiday, which combined the mid-Autumn festival and National Day, were slightly higher than 2019 levels before the pandemic, official figures showed.

But activity in the stricken property market, which analysts say lies at the heart of China’s economic woes, remained lacklustre, with fewer people than expected inspired by the holiday cheer to buy a new home.

With China’s third-quarter gross domestic product data expected next week, analysts will be looking for signs that Beijing will continue to support the recovery with sustained stimulus measures.

“The economy is resilient,” said Heron Lim, greater China economist at Moody’s Analytics. “But in terms of strong growth, that is still missing.”

China’s economy was expected to rebound decisively this year after Covid lockdowns in 2022 but a weak property market has undermined consumer confidence, while lagging foreign demand for the country’s exports has hit trade and manufacturing.

Policymakers have responded with cuts to mortgage requirements and interest rates, but have implemented piecemeal stimulus measures in a bid to avoid adding to growing public debt.

State media lauded the Golden Week holiday as a success, noting “bustling scenes” across the country as “the latest sign of . . . China’s steady economic recovery, in stark contrast to the dire predictions made by western media and politicians”.

But initial estimates for domestic tourism fell short of forecasts. The Ministry of Culture and Tourism said the number of domestic travellers during the break was 4.1 per cent above 2019 levels, and domestic tourism revenue was 1.5 per cent higher. Prior to the holiday, the government had projected visitor numbers would rise 7.8 per cent and revenue 3.7 per cent, Goldman Sachs said.

Tourism revenue per head was 2 per cent below 2019 levels — an improvement from the minus 16 per cent recorded during the Dragon Boat public holiday in June. Box office revenue was also well below pre-pandemic levels.

In the real estate sector, average daily sales volumes by area fell 17 per cent compared with 2022, according to data from China Index Holdings, which tracks 35 cities.

“The property sector showed signs of weakening again, despite the raft of easing measures rolled out in September,” Nomura economists wrote in a research note, adding that the easing of buyer restrictions in China’s top-tier cities might come at the expense of demand in smaller cities.

In Hong Kong, a popular destination for mainland tourists, the daily average of visitors from across the border reached 70 per cent of comparable figures from 2017 and 2018, before Covid and anti-government protests rocked the territory.

But mainland visitors spent less per capita on high-value luxury goods and services, analysts said.

Tourists “now prefer social media check-ins over shopping” during holiday trips, according to Oliver Tong, head of retail in Hong Kong for real estate services firm JLL. “Retailers are losing their confidence in the business prospects of the Chinese new year in 2024.”

Ray Chui, chair of Kam Kee Holdings, which runs more than 40 restaurants across the city, said holiday revenue was about 75 per cent of 2018 levels.

“It is more about getting the experience than spending now,” Chui said. In the past tourists spent an average of up to HK$300 ($38) per person, he said. “Now it is around HK$80.”

In Macau, the gambling hub that relies heavily on mainland tourists, visitor numbers reached 932,000, with average daily arrivals hitting about 84 per cent of the equivalent figure for 2019, the city’s tourism authority said.

Average daily gross gaming revenue during the holiday was estimated at 830mn patacas ($103mn), up nearly 30 per cent from the Labour Day holiday this year, JPMorgan analyst DS Kim said.

The figures were “much better than we and the market had feared”, Kim said, pointing to a faster recovery of mass market gamblers.

While casinos benefited, JLL said visitors did not splash out at the enclave’s jewellers and boutiques.

Analysts warned that signs of stabilisation remained fragile given the weakness in the property services sectors, while elevated interest rates in China’s trading partners would hit demand for its exports.

Nomura raised its gross domestic product forecast for 2023 to 4.8 per cent from 4.6 per cent, but maintained a projection of 3.9 per cent for the following year and a “cautious growth outlook”.

“We expect Beijing will have to do more to stabilise growth in the near future,” analysts said.

Top economist reveals his personal investment strategy on the FT’s Money Clinic podcast

Mohamed El-Erian, a leading economist, has said he feels “uncomfortable” investing his personal wealth in the stock market and has diversified away from equities as central banks battle to tame inflation.

In an interview with the FT’s Money Clinic podcast, El-Erian said he had adopted a “barbell approach”, allocating more of his personal portfolio to low-risk cash and cash equivalents paying decent rates of interest, while at the same time increasing his exposure to much higher risk distressed debt situations to balance this out.

“If you are uncomfortable in the stock market — as I am, by the way — then there’s a really good place to park your money where you can get paid 4 to 5 per cent on your money and that will compound,” he said, extolling the virtues of top interest-paying cash savings accounts.

“And then on the other side, there’s a lot of opportunities in what’s called distressed investing in private credit and things like that.”

He stressed that he was able to take this position as an experienced investor, cautioning that the barbell approach would not be suitable for novice investors.

El-Erian is chief economic adviser at Allianz, the parent company of Pimco, a big provider of bonds and fixed income investments, where he formerly served as chief executive. He is a contributing editor to the Financial Times.

“The time will come when I’ll be much more comfortable increasing my equity exposure, but I’ve been quite cautious,” he added, referring to volatility in both the equity and bond markets as rates are expected to stay higher for longer.

“Slowly, over the next few years, we’re going to go back to something more normal where traditional correlations and therefore traditional risk mitigation come back . . . I can tell you about the destination, but the journey is really painful.”

Given the current outlook, he said, the three qualities investors needed the most were resilience, optionality and agility.

“Resilience, meaning you can absorb a mistake. Optionality, an open mind. You need to recognise that there are certain things you don’t know. You need to think differently. Finally, agility; the ability to move quickly, and just to be clear, this is not just for investing. I think both governments and CEOs have to ask themselves every day. How’s my resilience? How’s my optionality? How’s my agility?”

El-Erian also spoke about the themes of his latest co-authored book Permacrisis: A plan to fix a fractured world, and revealed that his earliest money memory was playing games of blackjack with his uncle growing up in Egypt as a young boy of five or six. “He had, compared to me, an infinite amount of money, so ultimately he always prevailed,” he said.

To listen to the full episode, click on the podcast player above or search for “Money Clinic” wherever you get your podcasts.