The great rotation being driven by rising bond yields.
In recent months, the US 10-year treasury yield has moved sharply higher from 0.5% to 1.5%. Whilst broader share indices have been stable, a great rotation is taking place beneith the surface. We thought it would be useful for investors to dig a little deeper into the mechanics of bond pricing and explain why it is driving a rotation in asset allocation globally. Finally, we discuss portfolio positioning, to stay ahead of this rotation.
Source: Bloomberg, Watermark Funds Management
What is the 10 year yield?
The 10 year yield is the return one receives for buying a 10 year government bond and holding it to maturity. The nominal yield is a combination of the underlying real yield + inflation. The key determinant of both is expectation of future growth. Higher future growth will push up expectation for both future real interest rates and inflation. This links directly into the short term cash rate which is set by the central bank.
The yield on the 10 year bond is the sum of expectations of where the short term cash rate (set by the Central Bank) will be in each individual year out for 10. This is referred to as the term structure. The yield on the 10 year Sovereign bond is the “risk free discount rate” proxy used to value shares and other risk assets.
Why are yields moving?
In response to the pandemic, we have unprecedented government stimulus, alongside quantitative easing and the lowest cash rate on record. Spending is buoyant, as consumers have excess savings to spend This is coming at a time when we have the global economy emerging from lockdowns and reaccelerating rapidly. As central banks are expected to keep cash rates very low for years to come, inflation expectation are now rising in the medium to longer term. In a nutshell, yields are far too low for the strength of the recovery that is unfolding.
Why does it matter for equities?
It all comes down to corporate finance 101: the time value of money. The value of a share is the present value of future cashflows discounted at an appropriate discount rate (the risk-free rate plus an equity risk premium). Very low interest rates have been a key driver of shares in recent years and especially those with long dated cash flows (growth shares).
Risk free rates
When the risk-free rate approaches zero, long dated cash flows are only slightly less valuable than shorter dated ones. This means technology /growth shares where profits are further out in the future become vastly more valuable (see Xero’s cash flow profile below). In contrast, if we consider the cash flows of a low growth value share, such as a bank, the cash flows are immediate and hardly grow. (refer to CBA in chart below). When rates were falling, UBS called this thematic well, telling investors to buy DIG stocks (defensive income growth). In the real asset world, it was referred to it as a search for yield.
Source: Watermark Funds Management
What does this mean for different sectors?
The nature of the pandemic makes some traditional relationships much more nuanced. The global economy is pivoting from “stay at home” to an “away from home” way of life. We go through ramifications in general terms below.
- Value/late cycle cyclicals
- Banks benefit from rising rates on their significant cash holdings
- Banks will borrow short and lend long- they benefit from a steepening term structure.
- As credit cycle improves, they can release capital (unwind provisions)
- Commodities are considered hard assets and a good hedge against inflation
- Global demand is recovering quickly and there has been underinvested since the mining downturn- commodity markets are tightening and prices are surging.
- Surplus cash to be returned to shareholders
- Cheap and most impacted by pandemic disruption
- Levered to a recovery economic activity ie construction
- Beneficiary of the “stay at home” thematic expected to unwind
- Fewer cash flows in early years
- Real Assets – Property/Infrastructure
- Traditionally a yield sector, like a bond rising yields are a negative
- Carry higher levels of debt, so rising interest rates are a headwind
- Certain sub-segments are benefiting as economies open up again, ie Airports and retail REITs
- See minimal benefit from increased economic activity. Population growth is as good as it gets.
- Usually yield generative stocks with low-risk earnings, low beta
- Industries typically resilient during the lock down
How is Watermark positioned for this?
Whilst stock selection is the major driver in our investment process these major shifts cannot be ignored.
In the medium term we are looking for:
- Value shares that benefit from the reopening of the economy. Value can mean low growth of low quality. Many shares are cheap for a reason- we look to avoid troubled business irrespective the factor basket they are in.
- Commodities are well supported as the global economy recovers. A favourable inflation/yield environment is always good for commodities. There has been an underinvestment in the sector post the mining boom/bust- the shift the renewables and EV in particular will insure commodity markets remain tight.
We are avoiding:
- We still believe the tech companies will generate huge amounts of shareholder value regardless of what the yield environment holds. However, tech very expensive, speculative technology is risky in this climate and should be avoided.
- Defensive income shares such as infrastructure and utilities will underperform. However, we look favourably on those that will benefit from reopening, such as airports and Telstra (they lost $0.5 of profit from pandemic principally international roaming fees).
10 y correlation of weekly returns vs. the market. Global equities
Indexed returns in Europe since 2005