What the surge in UK gilt yields could mean for UK equities

UK government bond, or gilt, yields continue to rise inexorably, for all that Prime Minister Andy Burnham and Chancellor of the Exchequer John Healey continue to make all of the right noises by targeting growth while trying to avoid grandiloquent and expensive-sounding promises. All eyes are now focused on the Budget, scheduled for 28 October, to see what the fledgling administration will offer when it comes to spending and the funding of that investment.

Confronted by sticky inflation, an annual budget deficit of some 5% of GDP, and an aggregate deficit that represents 95% of total output, bond vigilantes are demanding higher returns in compensation for the dangers they see here. As a result, the benchmark ten-year gilt yield stands at levels last seen in 2008, while the thirty-year paper stands at 6% for the first time since 1998.

UK gilt yields continue to creep higher to multi-year highs

The question now for advisers and clients is whether those yields are tempting enough to persuade them to increase their strategic portfolio allocations to gilts, perhaps at the expense of equities, in the UK or elsewhere.

Wider context

It is possible to argue that this increase in UK gilt yields is nothing more than a return to something akin to ‘normal,’ after the aberration of the post-Great Financial Crisis era, when central bank policies intentionally repressed returns on cash and bond yields alike from 2008 until the turn of this decade.

The picture may not be as black as it seems for other reasons:

• Firstly, the rise in gilt yields is steady one, and does not smack of the panic in the wake of the Truss-Kwarteng fiscal statement of autumn 2022.
• Secondly, the premium the UK Government pays to borrow for ten years relative to its American counterpart is shrinking. This may mean the UK is not the most fiscally incontinent Western nation, in the eyes of the bond market. Japanese JGB yields are soaring, too.

UK bond yield premium relative to the USA is shrinking

• Finally, that dubious title may belong to France, whose ten-year Obligations Assimilables du Trésor (OATs) now offer a higher yield than ten-year Italian Buoni del Tesoro Poliennali (BTPs), for what looks like the first time ever. If there is going to be a bond market crisis, it seems more likely to start in Paris than London right now, especially as two of three leading candidates in France’s April 2027 Presidential election, Marine Le Pen of the Rassemblement National (RN) on the right and Jean-Luc Mélonchon of La France Insoumise on the left are both championing more government spending, not less, without much indication of how to fund it.

The yield on benchmark French OATs is soaring

Cash and carry

Whether that bleak background makes gilts more or less attractive from a bond allocation and yield points of view is something only advisers and clients can decide for themselves.

Some may feel that the 5.40% yield available on 10-year gilts is attractive, firstly if they are seeking income, and especially if they feel that return is sufficient compensation for the potential dangers posed by inflation, interest rate movements, default, and liquidity.

Such a view has potential implications for UK equities, though.

The gap between the benchmark ten-year gilt yield and the forecast dividend yield on the FTSE 100 is now more than two full percentage points, based on aggregated consensus forecasts for all of the stock market index’s members. That is the biggest premium on the ten-year gilt since summer 2007 and could tempt any adviser or client who is nervous about the economic outlook and feels that inflation is not about to break out to the upside, especially if they feel that any market dislocation will see the Bank of England turn to QE and financial repression once more.

The ten-year gilt now offers a hefty premium yield compared to the FTSE 100

• The total cash yield premium available on UK equities is shrinking. Analysts expect the FTSE 100 to pay out £90.3 billion in dividends in 2026, an all-time high. The index’s members have also declared £46.7 billion in share buybacks, while takeover bids for five FTSE 100 stocks, if they all go through, top up the cash pot by another £46.8 billion. Add those three together and cash returns from the FTSE 100 could hit £183.8 billion, with the possibility of more buybacks to come, assuming analysts’ dividend forecasts are accurate. That represents 7.1% of the FTSE 100’s £2.7 billion market capitalisation but it represents a premium of just 1.7 percentage points compared to the ten-year gilt yield.

The FTSE 100 does offer additional sources of cash returns

• Consensus earnings forecasts for the FTSE 100 put the benchmark index on 13.5 forward earnings for 2026. That’s another way of saying the earnings yield of the index is 7.4%. That figure still stands up well compared to gilts at face value, but a two-percentage point (“equity risk”) premium does not look particularly fat, given how equities can go down as well as up, whereas most UK gilts redeem at par and thus offer capital protection (at least in nominal terms).

Ratings game

Weight and the handicapper can stop even champion thoroughbred racehorses, and higher interest rates eventually slow down, or halt, share prices and equity indices, at least if history is any guide.

The tricky bit is no-one quite knows what the trigger level may be, in terms of relative yields and valuations. With gilt yields as they are, the price (or multiple) in the price-to-earnings (PE) ratio may not rise much from here, so the upside in UK equities may have to come from earnings growth, where analysts do remain optimistic, given forecasts for profit increases of 9% and 6% respectively in 2027 and 2028.

Past performance is not a guide to future performance and some investments need to be held for the long term.