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Uncertainty? What Uncertainty?

For some time we’ve been worried about the level of uncertainty surrounding the election.

There’s an old (but true) cliché that markets hate uncertainty. As a result, we have been concerned about market volatility around what was billed as the most uncertain election in memory, especially in the event of a hung parliament.

In the end, we have certainty, not uncertainty. At the time of writing it is not clear if the Conservatives have got a true majority (i.e more than 326 seats), but they certainty have a majority in practice.

That’s not to say we have not seen volatility. For example, the FTSE dropped as low as 6,830 yesterday having been at 7,100 only a few weeks ago. Gilt yields went up to around 2%, having been 1.5% until recently.

This morning the FTSE is up around 1.7% as I write to around 7,000, and gilt yields have dropped back to 1.8%.

Meanwhile the pound has been extremely volatile, especially against the Euro. Two weeks ago you could buy 1.40 Euros for every pound, but this dropped to 1.34 yesterday. This morning it is back to almost 1.38.

However, whilst some of this was down to the election, some volatility was down to some very significant market events elsewhere.

Bonds and equities become correlated

We’ve been worried for some time that government bonds (such as gilts) and equity markets have been becoming more correlated. Here’s my blog from a couple of months ago Diworsification 

Nowhere has this been more pronounced than in Europe. In fact, you can add the Euro exchange rate to the mix.

As the European Central Bank (ECB) has launched their quantitative easing (QE) programme, the Euro has gone down, whilst stockmarkets and bonds (especially German government bonds known as bunds) have gone up all at the same time.

As bonds go up their yields go down. A German 10 year bund just a week ago yielded 0.074% pa – this is the interest rate you would be paid for lending to Germany for a decade. Basically zero. This was clearly insane but many felt this would remain the case for some time, whilst the ECB were buying bonds as part of QE.

However, bonds have rapidly sold off in the past few days. At one point yesterday the 10 year bund yielded 0.8%. The yield had moved 1,100% in around a week! That’s not to say investors have lost anything like that, but it’s a startling number nonetheless!

At the same time that was happening, the Euro was strengthening and the stockmarkets were plummeting.

However, around lunchtime yesterday German bunds turned around and yields dropped back to 0.6%. That is massive volatility for a supposedly low risk asset class! As bond yields recovered, so did equity markets.

Whilst nobody quite knows why there has been such volatility in bonds, here is our working theory.

The US economic growth numbers have been poor. Their central bank has hinted that rate rises will be delayed from the expected increase in June. This has caused the previously strong dollar to weaken against the Euro.

At the same time, oil prices have rebounded from around $50 to around $70 a barrel. This means worries about deflation have receded. Deflation was one of the justifications for low bond yields – if inflation is low then the real yield is higher.

These two factors had a joint effect on the currency and bond yields, which then fed through into stocks.

We live in a global economy and it is one which remains dysfunctional. Stimulus like QE has been required to keep the world growing, but it has distorted markets. Bonds, equities and the currency are not all meant to move together at the same time!

The Plan

Part of today’s recovery in the FTSE and in UK gilts has been election related. Part of this is related to a calming of the storm in global bond markets.

We had always said that if the market dropped far enough we would have cash to put to work. The market fall was not deep enough to hit our planned trigger so we have not yet invested this cash.

We have previously felt that after the election we may invest elsewhere if we had not had the opportunity to top up equities at a low. However, with the continuing uncertainty in global markets we may keep our powder dry a little longer.

With markets so distorted, it makes sense to remain cautious.

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