By Jamie Mariani – Partner, Morenti Wealth Partners
Equity markets have spent much of the past year at or near record highs, powered by enthusiasm for artificial intelligence and a resilient global economy. At the same time, and with far less fanfare, long-term government bond yields, the interest rate that even the world’s most creditworthy borrowers must now pay to raise money for 10 or 30 years, have climbed to levels not seen since before the Global Financial Crisis.
Two of the most closely watched markets in the world appear to be telling two very different stories. History suggests that when bond and equity markets disagree this sharply, one of them is usually wrong. We don’t know which, and this isn’t an attempt to guess. But for anyone holding a portfolio weighted heavily towards equities, and there are more of these than you might expect, it’s worth understanding why.
Rising bond yields aren’t a prediction of what happens next. They’re a reminder that markets price risk, and right now, two major markets disagree about how much of it there is.
This builds on a theme we explored in an earlier note, Why the 60/40 Portfolio Failed and What Investors Should Do Now: that the old rules for how bonds and equities behave are regime-dependent, not fixed, and the post-COVID regime looks different from the one most savers built their portfolios in.
Why Are Government Bond Yields Rising?
There isn’t one single cause. Government borrowing has remained elevated in most major economies since the COVID pandemic, what we’ve previously called ‘fiscal dominance’, where governments prioritise spending over inflation control (we set out the UK-specific version of this story, and its tax implications, in Debt and Taxes: The Long Squeeze).
Deglobalisation is reversing decades of disinflationary pressure from cheap imported goods. The scale of capital investment required to build out AI infrastructure is enormous, and all of it needs funding. Most recently, the Federal Reserve chair’s decision to step back from detailed forward guidance has been read by markets as an invitation for a larger “term premium”; investors demanding more compensation for lending over the long run.
The result is visible across every major developed economy, not just the UK: the cost of long-term government borrowing has been rising steadily (Chart 1). One old rule of thumb is worth keeping in mind: “Don’t fight the Fed”. Central banks, and increasingly treasuries themselves, retain real tools to lean against a bond market move they judge has gone too far, and recent history suggests they’re willing to use them.
Chart 1: 10 Year Government Bond Yields, Major Economies (2007-present)
Are Bond Yields Signalling Trouble for Equity Markets?
A government bond yield is (theoretically) the “risk-free” rate of return available to investors. The higher it climbs, the more expensive equities look by comparison, because the future profits a company is expected to earn are worth less today when discounted at a higher rate. That’s the textbook relationship, but it’s only half the story, and arguably the less important half.
Higher yields also raise the real cost of debt across the economy: for companies refinancing maturing bonds, for smaller businesses reliant on bank lending, and for households with mortgages. It’s usually this second, more mechanical channel, tighter financing conditions squeezing growth and profits directly, rather than the abstract effect on discount rates, that eventually forces a correction.
What’s unusual is that equity valuations, particularly in the US, have remained elevated as yields have risen. We note the Shiller CAPE PE, the ‘Buffett Indicator’ (US stock market /GDP), Tobin’s Q (market value to replacement cost of assets) and the Household Equity measure as proof of high equity valuation levels. That’s the disconnect at the heart of this piece: bond and equity markets both claim to be pricing risk correctly, and on the numbers, they can’t both be right.
None of these equity valuation measures times a market well over the short run, and they carry a real critique of their own: with more than half of US equity fund assets now in passive vehicles, a growing share of buying is mechanical, index funds allocate capital by market-cap weight, not by valuation, so cash flows into equities regardless of price. This structural trend may help explain why valuations have stayed stretched for so long.
Some have drawn a comparison with 1987, when a sharp rise in bond yields preceded a sharp equity correction. The move in yields back then was considerably larger than what we’ve seen so far, so the parallel shouldn’t be overstated, but it’s a reminder these disconnects don’t always resolve themselves quietly.
Is UK Government Debt Riskier Than Other Countries?
Within this broader move, the UK stands out. Chart 2 plots UK 10-year gilt yields against the range of yields across the UK’s G7 peers; the US, Germany, France, Japan, Italy and Canada. For much of the period shown, the UK sat comfortably within that range. Since the pandemic, that has changed: UK yields have persistently traded towards the top of the G7 range.
In other words, markets are pricing UK government debt as relatively riskier than that of its major peers, a distinctly post-COVID phenomenon, not a historical constant.
It’s a third data point alongside two we’ve flagged before: a weak pound and a lagging domestic stock market over the long-term, covered in an earlier note, Is Investing in the UK Holding Your Portfolio Back?, taken together, currency, equities and now bonds are telling a fairly consistent story about how international investors currently view the UK.
Chart 2: UK vs G7 – 10-Year government yields, G7 min–max range shaded (2007-present)
Keep this in perspective, though. In our view this is not the UK of 1976, and there’s an important distinction between a government’s solvency risk and the everyday volatility of a bond’s market price. The UK borrows almost entirely in its own currency and controls its own central bank, a materially different position to a country forced to borrow in a currency it cannot print. That said, bond prices, and bond funds, can still fall significantly along the way, particularly where the underlying isn’t held to maturity.
How Should Investors Respond to Rising Bond Yields?
We’re not suggesting anyone abandon equities or try to time this. Nobody rings a bell at the top of a market. But if your portfolio sits close to 100% equities, it’s worth asking whether that reflects a considered decision, or simply the fact that equities have performed so well for so long that moving away from them has felt unnecessary.
For long-term investors comfortable locking in mid-single-digit yields from high-quality government borrowers, today’s rates offer a genuine, lower-drama alternative to the risk of an equity correction at these valuations, provided the approach is built around credit quality, and managed with the mark-to-market risks in mind.
Why We Hold Gold and Commodities in Client Portfolios Today
There’s a related risk worth naming. As we set out in our note on the 60/40 portfolio, bonds have reliably cushioned equity losses during deflationary shocks, the Global Financial Crisis, the dot-com bust, but failed to do so in 2022, when an inflation shock sent both equities and bonds down together. Fiscal dominance and a structurally larger term premium raise the odds of a repeat, if the next shock comes from the supply side rather than a growth slowdown.
For many client portfolios, we hold a meaningful allocation to gold and broader commodities alongside equities and bonds, specifically to diversify against that scenario, one where both halves of a conventional 60/40 mix fall at once. The right weighting depends on individual circumstances, attitude to risk and required rates of return to meet retirement goals, key areas we work through with clients directly.
This continues to sit apart from how some within the wider investment management industry think about portfolio construction. We’ve had conversations with several large fund and ETF providers whose house view is that every holding in a portfolio should generate income. We think that’s an unhelpful constraint, not a rule, it locks in the assumptions of one specific historical regime, the low-inflation, income-scarce decade after the Global Financial Crisis, rather than the wider range of environments a retirement portfolio needs to survive. Gold and commodities don’t pay a coupon or a dividend. That has never been the point of holding them.
These are genuinely interlinked questions spanning inflation, currency, credit quality and portfolio construction, not one-size-fits-all territory. If you’d like an independent, second opinion on how your own portfolio, or a family member’s, is positioned for this environment, we’d be glad to talk it through.
If you would like to discuss how this affects your own portfolio, please get in touch.
About Morenti Wealth Partners
Morenti Wealth Partners is a trading style of Burgess and Lee Ltd, an independent financial advice firm specialising in retirement and inheritance tax planning. Morenti Wealth focuses on delivering clear, actionable strategies tailored to clients’ unique goals, stripping away unnecessary complexity and cost. Burgess and Lee Ltd is authorised and regulated by the Financial Conduct Authority (Firm Reference Number 160493).
Disclaimer
This article is for information only and does not constitute personal financial advice. We strive to provide accurate and up-to-date information, but investments carry risks, including the potential loss of capital. Government bonds are not free of risk, their market value can fall as well as rise, and the value of bond funds and ETFs can be affected by market conditions even where the underlying credit quality is unchanged. This article does not consider your individual circumstances. You should seek personalised advice before making financial decisions.
Media Contact
Richard Bourne – richard.bourne@morentiwealth.co.uk
