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Fund managers are uneasy about the future of yield stocks after a sell-off in bonds escalated a rush out of the former market darlings, and warned they could be in for more pain.
Bond yields are rising because of growing signs that inflation is being restored in advanced economies, on the expectation that big-spending fiscal policy will take over from monetary stimulus amid the evolving political firestorm that underscored the Brexit vote and the election of a populist United States president in Donald Trump.
In Australia, rates markets are now pricing in the chance of interest rate hikes from the Reserve Bank for the first time since 2014, tipping two basis points of easing 12 months out. Yields have risen about 80 basis points since August, which has fuelled a correction in the stocks that have benefited the most from falling interest rates: infrastructure, telcos, and property trusts.
"These stocks are now having their inevitable correction and with bond yields not even back to where they were a year ago, we believe this theme has a long way to play out," said Paul Fiani, head of equities at Integrity Investment Management. "Some have said 'it's different this time, it's a new paradigm', we hear these same noises every cycle and it never is."
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He doesn't own any yield favourites, and is in no rush to add any as they get cheaper. "We are not even thinking of buying these stocks, they will continue to face headwinds over multiple years.
"Even if the earnings streams remain defensive, when PE's [price-earnings multiples] halve from inflated levels, there is nothing defensive about halving your money," he said.
Ben Griffiths of Eley Griffiths Group pointed out there's a flipside to the bond market moves and favours "deep" cyclical stocks, such as chemicals and packaging companies, because they have the most leverage to an economic recovery.
"Bonds need to move appreciably higher to seriously derail the case for equities," he said. "Once equity investors satisfy themselves that rates are backing up in response to improving economic growth, then equities will be able to rally with greater certainty. This can continue until tactical allocators decide the risk premium over bonds no longer supports the buy case for equities." This is "some way off".
As the equity risk premium (the gap between the earnings yield and the bond yield) begins to contract, markets struggle. That premium "still sits nicely above 5 per cent", or 6.2 per cent for the Australian market.
In an inflection point like this, Mr Griffiths favours resources and mining services stocks, such as Mineral Resources, Independence Group and GR Engineering Services.
Paul Taylor, who manages the Fidelity Australian Equities Fund, observes that rates fell to such low levels that historically small changes in yields could potentially be more sinister.
"We went as far as we possibly could on the low side, basically zero. The interesting thing is going from zero to 2 or 3 [per cent] is a big move when you're at zero. The delta is quite significant and a lot of bonds were pricing in very low yields. It would take not as big a move today to do what happened in 1994," he said.
But in reality, it was impossible to say for sure if the latest rumblings are the start of a more persistent trend. The only thing investors can count on is higher volatility.
"With the change in interest rates, inflation and the US presidential issue as well, you're getting big volatility on small moves. A small change in the PMI or CPI are having a big impact. Those small changes could be part of a bigger trend, but the one thing that is happening is volatility is increasing," Mr Taylor said.
Peter Hall, the founder and chief investment officer of Hunter Hall International, painted a bearish picture for equities, saying, "there's too much complacency and there's not enough fear of the disruption and disorder that's about to be unleashed".
"Of course, we're going through a new era of political change," one that does not end with the election of Mr Trump. "Marine Le Pen is one terrorist incident away from becoming French president in the next elections," the contrarian fund manager told shareholders of his listed investment company in Sydney on Wednesday.
The Trump era, "threatens disorder, because Trump is not a believer in a cohesive world order he is a believer in American solutions for American problems and this is threatening the balance of interest rates and currencies, it's threatening the geopolitical balance, it's threatening trade relations. For example, Trump has said he wants to put a 45 per cent tariff on Chinese goods. The Chinese response is to depreciate the yuan.
"So we're getting into a phase where we could be getting into a currency war and a trade war." That is a departure from the past eight years where the United States, Europe, China and Japan have co-ordinated policy to support activity.
Meanwhile, S&P; 500 stocks are trading 26 times earnings, about the same as the 1987 peak and in "the same ballpark" as the 1929 peak. "I believe that valuations are too high when you think about the risks that the world is facing," Mr Hall said. Interest rates have bottomed, they will rise, and that reverberation in currency markets impacts real world economic activity.
He considers cash and gold equities to be defensive assets. But Mr Griffiths was unconvinced about adding gold miners. "A firmer US dollar works against gold, as do firming real interest rates," he said. "This of course may alter moving forward as inflationary expectations begin to grow.