Yields continue to rise, equities remain hopeful

There is not much one can add regarding the news, UK inflation remained stubbornly high, and as a result, the Bank of England raised interest rates by 50 basis points at yesterday’s meeting. The press claimed this was higher than the 25 basis points forecast, but the bond market had priced in 50 basis points pretty soon after the inflation data. Andrew Bailey, who has never been the most popular choice as the head of the Bank of England, was left to face the press. The monetary policy committee were between a rock and a hard place, likely to face criticism no matter what they did. Stocks across Europe, including the UK, fell on Thursday, as the bond market now prices in the possibility UK interest rates could rise above 6%.

The stubbornly high inflation rate in the UK was blamed on a release of a computer game, amongst other things. Red herrings, the reality is higher wages, and energy prices are the main contributors. Wages in the UK are growing almost 8% year over year. This compares with 5% in Europe and just over 4% in the US. Unlike the US, where long-term inflation expectations remain anchored close to 2%. The UK 10-year forward inflation expectations continue to rise. Currently, the 10-year breakeven is close to 4%.

The UK was not the only country yesterday to raise interest rates as Switzerland and Norway followed suit. Switzerland’s national bank lifted its policy rate for the fifth consecutive time by a quarter of a percentage to 1.75%. Despite the country’s inflation rate decreasing to 2.2% in May, compared to 2.6% in April. Jerome Powell, in his testimony to Congress, stuck to the script, reiterating that rates in the states will go higher again this year as the fight against inflation goes on. Central Banks, at present at least, feel reassured by the underlying resilience of the global economy; the soft landing view gathers traction, particularly whilst service spending remains strong.

The recovery in equities in the face of ever-increasing interest rates once again makes them look expensive compared to bonds as the equity risk premium falls to levels last seen in 2008. As technology stocks have once again propelled the valuation for the S&P 500 from almost 16X earnings to almost 20X, taking the earnings yield down to almost 5%. The equity risk premium, or the additional return one should expect for the additional risk one takes owning equities, is calculated against the 10-year US treasury yield, currently 3.8%. The current ERP is circa 1.2%, and the historical average is around 3.5%.