“Prediction is very difficult, especially if it is about the future.”
– Niels Bohr
Friday 5th March, 2021
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It has been a choppy period for markets since our last newsletter two weeks ago, with a rise in interest rates being the dominant narrative. The yield on the US 10Y reached 1.55% by Thursday’s close, up +21bps from 19/02, +60bps from the start of the year, and more than +100bps from the lows touched during the pandemic. These are not insignificant moves. As we have discussed previously, the steady rise in rates we have seen over the last 12 months has reflected both increasing risk appetite and rising inflation expectations, as investors have started to look past the pandemic into a world where demand roars back under an incredibly accommodative fiscal and monetary backdrop. Perhaps the easiest way to emphasise the role that inflation expectations have played so far is to point out that real (i.e., inflation adjusted) yields have actually fallen since March 2020! However, inflation expectations have not kept pace with nominal yields this year and we have started to see real rates creep up. Deutsche Bank produced an interesting article on the differing implications of rising nominal yields vs. rising real yields, the key takeaway being that while the relationship between nominal yields and credit spreads (one measure of corporate health) is rather convoluted, the correlation between real yields and credit spreads has become increasingly positive as corporate debt levels have risen… As such, a sustained rise in real rates would be cause for concern. For now, real rates remain ultra-low but this will be something to monitor going forward.
Nonetheless, this could have played a part in the market’s rather violent reaction to Powell’s comments yesterday, despite him striking what was seemingly a rather dovish tone. He did point out that the economic outlook was improving at the margin, but also reiterated that the US was “still a long way from our goals of maximum employment and inflation averaging 2%” and that the Fed would not make any knee-jerk reactions to higher inflation. However, the market was clearly hoping for some sort of explicit commitment to containing the rise in long-end yields – which was not forthcoming – and we saw equities fall sharply. This was particularly stark in the US, with the S&P 500 falling -1.9% in the wake of Powell’s comments and the NASDAQ by –2.4%. This brings their returns over the last 2 weeks to -3.5% and -8.3% respectively and leaves both of these US bellwethers more-or-less flat for the year. This is hardly the performance we would expect when the vaccine rollout has begun in earnest, economic data has surprised to the upside, and Congress is fast approaching agreement on a sizeable stimulus package. Why has this been the case?
It largely comes down to valuations and what was already priced in. The US stock market is dominated by the large, high growth tech companies that have formed the backbone of the market’s remarkable strength over the last 12 months. As has been discussed at length, these companies have been the ones able to capitalise on the stay-at-home economy and the acceleration of secular trends that were already in place prior to the pandemic (e.g., increased adoption of online payments)… Their growth rates have surged as a result. However, there is an argument that they look pricey by most traditional metrics and with an increase in the low rates used to justify many of these valuations, it is no surprise that we have seen such a pullback. It is also worth noting that many of these companies could actually see growth rates slump as the economy re-opens due to a high base effect and a partial return to previous consumption habits. Conversely, European equities have held up relatively well and have outperformed the US YTD (how often have we said that in recent years?). This is largely due to the prevalence of more cyclical, value sectors which tend to have more of their valuation tied up in current earnings, making them less sensitive to a rise in rates and more geared into an economic recovery. Europe’s large banking sector, an eternal laggard, has been a notable winner. Banks effectively borrow at the short-end of the curve and lend at the long-end, so their profitability has suffered meaningfully with the flattening of the yield curve in recent years (as well as the loan loss provisions they had to make as a result of the pandemic). The steepening of the yield curve has significantly improved their outlook and they have rallied in response – the STOXX 600 Banks Index is up +17% YTD!
It is clear that there is a confluence of forces at play. We do not have a crystal ball – and have not come across anyone who does (yet) – and the net impact on asset prices of rising inflationary expectations, higher interest rates, and a stronger economic backdrop is nigh on impossible to decipher. The only outcome that seems likely is that a regime of elevated volatility will prevail for the near future. While this does give us reason for caution, we are far from bearish. The latest pullback in asset prices was mostly a healthy correction in a market that was probably running a bit hot, but investment opportunities continue to abound for those with the stomach for them. Many of our highest conviction investments are in areas that are accused of having “unjustified” valuations, because we believe these companies are fundamentally changing the way that we live our lives for the better and their long-term earnings will reflect this. In other words, we think they are expensive for a reason. At the same time, there are clearly opportunities in the unloved sectors of the market. Look no further than the recent rally in European equities. All-in-all, we continue to advocate a balanced approach to investing, alongside a keen awareness of the underlying exposures, as careful portfolio construction can mitigate short-term price volatility while maintaining exposure to the long-term trends we aim to capture.
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