The link between bond yields and share prices over the past few weeks has spooked many investors but may be good news.

After almost reaching 6000 in mid-April, Australia’s S&P/ASX 200 equity index has retreated to below 5500 in early June, a fall of nearly 9%. Much of the decline can be attributed to a retreat in bank share prices which are down 17% over the same period. This is partly due to investor concerns about bank capital requirements and partly due to the recent rise in bond yields. Australian Commonwealth Government 10-year bond yields have risen from 2.35% per annum in mid-April to more than 3% per annum in early June. Similarly, German 10-year government bond yields have also jumped by a similar amount, from 0.15% per annum to 0.90% per annum, and Germany’s DAX share market index has fallen 10% over the same period.

This link between bond yields and share prices has worried investors as it meant bond and equity prices fell at the same time, hurting diversified multi-asset portfolios. However, the rapid rise in bond yields has been driven out of Europe as investors have shifted from expecting deflation and economic contraction, which pushed bond yields into (unsustainable) negative territory in much of Europe, to now expecting inflation and moderate economic growth. This readjustment has mostly run its course. It’s hard to see bond yields moving much higher short-term, particularly when central banks in Europe, Japan and Australia continue to cut rates and/or buy billions in longer term government bonds. Also, higher bond yields usually imply improvements in economic growth and moderate inflation, which is positive for equities.

Overall, a rise in bond yields from unsustainably negative levels and a pull-back in equity valuations, particularly in the prices of “bond like” bank stocks in Australia, can be healthy and remind investors that yield isn’t everything. Dividend yields can rapidly adjust higher and portfolios need to be well diversified so that they aren’t overly exposed to the single “bond yield” theme.

Our asset allocation summary:

• Cash: Hold an overweight position in cash to be able to take advantage of new opportunities when they arise, for example, a selloff in equities. We suggest shorter maturity term deposits over at call cash.
• Fixed income: We have an overweight position in fixed income until we identify opportunities in alternative investments to shift capital into. Developed world government bonds are very expensive and offer poor absolute value, so prefer products with limited interest rate risk. We suggest an equal split between Australian and (hedged) international bonds. Tactical income, absolute return fixed income strategies, floating rate corporate securities and short duration fixed income are all preferred over benchmark aware bond strategies.
• Australian equities:Remain underweight. Growth outlook is lower than other markets and valuations are above fair value. Favour selected industrials such as financials, healthcare and utilities. Hold positions in quality smaller companies.
• International equities: Given higher valuations in developed market shares, hold a neutral weighting. Maintain unhedged currency exposure for now. Favour Europe and Japan over the United States. Emerging markets are cheaper than developed markets so maintain exposure and favour Asia over other regions.
• Alternatives: Maintain a neutral allocation until opportunities emerge.
• Property: Hold a neutral allocation to commercial property. At current pricing, Australian and international property appears fair value. Favour international property securities over Australian.

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