Jonathan Marriott, Chief Investment Officer
Weighing up the appropriate amount of time to debate interest rates, bonds and inflation can be challenging; in reality, the largest contributors to risk in portfolios are equity holdings rather than fixed income positions. However, this week has demonstrated very clearly the link between bonds and equities. Bond yields have risen steeply, and equity markets have been giving up the gains made earlier in the year. Ten-year gilt yields have more than quadrupled this year from 0.18% to 0.81% and their US counterparts have risen from 0.91% to 1.48%. Within equity markets, the growth stocks that came through the pandemic that sell off best, have suffered most as long dated interest rates rose. You may ask why growth is hit hardest.
The value in any equity can be seen as the present value of the future cash flows generated by that company. This is calculated using an appropriate discount rate, which is typically measured by the prevailing interest rate. The next year’s earnings can be valued relative to short dated bond yields, but if earnings are ten years away, then the discount rate used to calculate it should arguably be a ten-year rate. In growth companies we are valuing earnings that grow out into the future, but the so-called value companies are valued on present earnings, hence long dated rates are less important. Assets such as commodities and crypto currencies have no cash flows and the price is more a matter of supply and demand. Gold, which has only minor industrial use, may also be seen as a very long dated asset and has suffered as long rates rose. The future cash flows are influenced by the nature of the business, the underlying economic conditions and the cost of financing. Rising interest rates slow economic growth and raise the borrowing costs which can also hurt earnings. Banks, which take short-term deposits but lend on a long-term basis, benefit when long yields rise relative to short interest rates. Bank equities have generally done well this year as the yield curve has risen.
Yields have risen across the globe and many central banks have expressed their concern. They have been buying bonds to support the economy and if the yield curve steepening continues, they may be put in a position to skew their buying to the long end to reduce the damage. Fed Chair, Jay Powell, speaking this week did not express particular concern about the bond market but made it clear that he did not expect to raise rates any time soon. He reiterated their belief that any rise in inflation will be temporary and it would be another three years until they meet their 2% target. He also talked about the full employment target, particularly for minorities. US jobless claims this week were still above the level seen post the 2008/9 financial crisis. Getting those people back into jobs may be difficult given the numbers of business that have closed during the pandemic.
Central banks do not seem prepared to tighten any time soon, so why are bonds selling off? It appears to be all about inflation fears. Inflation will rise this year due to the base effect of low prices for oil and commodities during the pandemic shut down last year. The spot price of West Texas crude oil actually went briefly negative last year as supply exceeded demand and storage capacity. The fear is that the stimulus, on top of a post pandemic recovery, will push inflation up over the long run. Powell clearly thinks this is not an issue but the market fears that is the case.
Our view leans towards the Fed view that inflation rise this year is temporary and that post pandemic we return to a low growth low inflation world. Technological advances, robotics, artificial intelligence and aging populations are all deflationary. In the long run, growth stocks will outperform again and interest rate rises are still some way away. Central banks have bailed out many companies during the pandemic by providing cheap loans. Governments have helped them with costs by launching schemes such a Payroll Protection Program in the US and the Furlough scheme in the UK. Some of these companies remain highly indebted and having saved them, they will not want to see them go out of business because of higher financing costs.
The sell-off in bonds may not be over, but we are beginning to see some value and encourage those that are underweight relative to any benchmark to start to reduce the underweight. Yields are higher in the US than their European developed market counterparts, so this may be a good place to start.
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