Last year if one managed to time the exit correctly, at the end(!) of May, most of 2013's available returns would have been realised. This year things are looking different. Firstly stock markets are hardly up and secondly the first 4 months of 2014 have seen an overweight of doubt and unease amongst market participants, compared with the first months of 2013 when the confidence hike in the global economic recovery drove up valuations. I also suspect that equity markets have misinterpreted the rebound in government bonds as a sign of a potentially more significant downturn in market sentiment. The much observed 10 year government bond/gilt rates have fallen from the 3% mark they reached back in December to 2.6 - 2.7%. The inverse relationship between yields and bond values has made gilts and treasuries some of the best performers in 2014 so far. Falling yields are usually a sign of a deterioration of market sentiment and as a result the usual ("perma-") bear commentators have taken this as evidence that the end of this market cycle is nigh (again). I disagree. Most of the observed fall is explained by firstly the previous overshooting at the end of last year and secondly and in my mind of far greater relevance, a marked change in inflation expectations, as the chart below shows.
The red area shows the change in implied inflation expectation as can be derived from the prices of inflation linked government bonds. Since the beginning of the year this component part of long term yields has fallen by almost as much as the yields have fallen in total. The rationale for this is that more and more investors have come to realise that despite the QE programs of the past years, inflation in the next years is likely to remain below average, because surplus capacities and weak consumer demand will keep inflation pressures at bay longer than is normally the case. The resultant expectation adjustment to such a "Lowflation" environment has resulted in a temporary yield step down. There has also been a limited 'flight to safety' downward pressure over Ukraine/Neo-Cold-War concerns, but with the economic climate continuing to improve I expect 10 year gilt yields to now gradually move back to the 3% level. After last year's violent move from 1.6 to 3% this move is much smaller and potentially so gradual that together with yield payments, outright losses from gilts seem much less likely this year.
Now back to the developments mentioned at the beginning. The European Central Bank (ECB) surprised this week, not by keeping rates unchanged, but by announcing that they will be easing monetary conditions after their next meeting. Mario Draghi stated that the governing council was dissatisfied with the projected path of inflation and therefore "comfortable to act next time". After getting peripheral Eurozone government bond yields very comfortably under control (Ireland now has borrowing costs below those of the UK and Spain's and Italy's 10 year yields have dropped below 3%) with his 2012 "whatever it takes" threat, the Eurozone is now challenged by the resurging strength of the Euro and very subpar credit availability to expanding businesses. When looking at the above chart this is not overly surprising, as the Eurozone's monetary base has shrunk because of its impaired banking sector, while the economy is expanding, leading to very tight credit and capital inflows from abroad pushing up the currency.
The other meaningful development has been around Ukraine. Contrary to how it may seem against the newsflow, from a global economic and markets perspective the deterioration of the conflict towards a civil war has actually led to a limitation of the wider economic consequences. Paired with Putin's more conciliatory tone towards the end of the week, when he spoke of pulling back Russian troops from the border and advising the separatists not to pursue the independence referendum, it lowers the probability of the West having to impose more painful sanctions. Markets reacted positively with the Russian MICEX index rising more than 7%. As sad as the developments are for Ukraine's people, the geopolitical dimension of this conflict has just been significantly reduced.
A raft of positive economic data, with the exception of Japan and the Emerging markets, helped to push markets higher and particularly the US Fed's Yellen's regular testimony before Congress assured markets that monetary tightening is still far out on the horizon.
Altogether therefore a strong start to May and a good perspective that over the coming months the UK and European equity markets will break out of their trading ranges and reflect the more resilient and positive economic growth picture that is presenting itself.
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