Rudi's View | Jan 13 2021
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In today's Rudi's View:
-All Eyes On US Treasuries
By Rudi Filapek-Vandyck, Editor FNArena
All Eyes On US Treasuries
Last week, someone posted a comment on Twitter along the lines of: Global growth is recovering strongly, consumer spending is picking up, central banks retain their accommodative policies and now the new Biden administration will inject a few extra trillions into the US economy. What could possibly go wrong in 2021?
My response was: In short: higher bond yields.
Equity markets usually ignore whatever happens in bond markets with most investors either zooming in on company specific matters or trying to read market momentum from price charts, until the bond market makes them pay attention. Last year, the most important bond yield in our lifetime, the 10 year US Treasury, touched near 0.50% twice; in early March and again in early August.
Since then the yield has been steadily creeping higher. By now the US 10yr-yield is approaching the highest point post global share markets sell-off in 2020, at 1.18%. More importantly, the yield is up more than 100% (double) what it was at both low points last year. Admittedly, we are still living through an era of exceptionally low interest rates and bond yields, and this remains the case.
But when the most important bond yield doubles in less than six months, institutional investors start paying attention. No surprise thus, the acceleration in upward movement witnessed this month has put the breaks on the ASX200 in Australia. As a matter of fact, it can be argued the Australian share market, when viewed from the index level, has been moving inside a sideways pattern since mid-November last year.
That's when the 10yr-yield started approaching 1%.
Bond Yield Matters
The first question that comes to mind is: why are bond yields rising? The second is probably: why is this a negative for equities?
Bond markets usually try to sniff out what kind of price inflation lays on the horizon. Standard economic thinking predicts that as economies recover and people find more jobs while both households and businesses increase spending, this will, at a delay, lead to higher inflation in consumer prices.
A view further supported by ongoing bond buying programs from the world's most powerful central banks ("money printing"), now assisted with increasing fiscal stimulus from governments, while energy and commodity prices are equally rising.
According to sophisticated modeling, this year's economic recovery amid ongoing support from central banks and governments implies the 10 year bond yield should be at or near 2%, which is still nearly double where it is today. Wall Street consensus has been converging around the 2% level in recent weeks.
This, however, does not automatically imply bond yields will inevitably rise to that level over the year. Strategists at Citi, for example, also mentioned the 2% implied fair level, but they don't believe the 10yr-yield will move much past 1.45%.
Let's hope not, because if 10yr bond yields were to move to 2% this year, this would without the slightest doubt translate into a significant downturn for global equities; the kind that has all newspaper headlines using terms such as "crash" and "meltdown".
The reason is because valuations for all assets known to us are directly or indirectly determined by and derived from the US 10yr-yield.
Maybe the easiest comparison is through the enormous spike in oil prices that occurred in the first half of 2008. At first, rising oil prices are seen as a logical consequence of better economic conditions, and thus share prices of energy companies go along with the ride, but ultimately, if that oil price keeps rising, this turns into a negative because economic growth is stymied, destroying demand, and thus killing off the uptrend for energy prices and share prices for energy producers.
I am sure many among you still recall the boom and subsequent carnage that occurred back in 2008.
The principle of rising bond yields works along the same lines. First it is but a logical response. At some point, investors will pause and take note. If bond yields continue to rise, asset valuations need a re-set. In practical terms, this is always a painful process. This applies in particular when investor sentiment is euphoric and asset prices highly valued.
Market strategists at Morgan Stanley, when toying with the idea that 10yr-yields can potentially rise to 2% in 2021, recently estimated such a move equals a sell-off in equities to the tune of -20% for banks, industrials and cyclicals and -30% for technology stocks and bond proxies (all else remaining equal).
The reason why quality, structural growers and technology stocks in general are punished more than your average bank or commodity producer is because the former have benefited more from falling bond yields in the past, plus their higher valuations need a larger re-set when yields move higher.
This is why the momentum switch that occurred in November last year has proved different from the failed attempts prior: rising bond yields are providing the necessary back-up for the share market's new preference for banks, commodities and cyclical industrials.
Market Trends In Reverse
Bond markets are just as susceptible to fads and trends as are equities and other assets. While many investment experts and market commentators treat all signals from global bonds as "fact", the truth is bond markets are regularly plain wrong in their pricing and signalling.
Remember late 2016 when everybody, and I mean everybody, was declaring the bull market in global bonds was finished and interest rates had only one way to go? It lasted about six months and central banks were subsequently forced to go farther and deeper, and bond yields ultimately ended at lower yields.
In plain English: bond markets had it wrong. And so did everybody else. But it was painful holding on to shares that temporarily landed on the wrong side of the switch in market momentum.
This time is proving no different. Hands up who predicted CSL shares would fall to near $270, which equals the lowest price post March last year? Probably the best example to point out within this context of reversed share market momentum is that of local superstar investor Hamish Douglass, as illustrated through the share price of Magellan Financial Group ((MFG)).
Prior to the pandemic, Magellan's share price had comfortably rallied above $70. In the post-bear market recovery Magellan's share price has repeatedly touched $65. Since the move up in US 10yr-yields, Magellan's share price has sunk below $50. This is quite a painful adjustment, even if we disregard that pre-March rally, it still translates to -20% in less than three months.
In the background of all of this, Magellan's investment strategy, centred around structural growth, disruption and quality, is no longer handsomely outperforming all value-based strategies that are now enjoying come-back glory and responsibility for index moves post October. Magellan's Global Fund has turned into a benchmark underperformer. Take that as a sign of the sharp reversal in market momentum.
The short summary of the consequences of rising bond yields in equity markets is: previous winners are now among the laggards, while previous laggards are enjoying their moment under the sun.
Portfolio Management Equals Risk Management
For good measure, there are still plenty of economists and other experts around who do not believe consumer price inflation is about to make a decisive come-back this year, or next. Structural changes to economies combined with technological advances and disruption in a world burdened by debt means the old one-on-one translation into higher inflation does not necessarily apply.
And there are plenty of question marks about the trajectory and strength of this year's economic recovery, as well as the exact execution by the Biden administration that starts off with the flimsiest of majorities in Congress for any new US president since 1900.
Beyond the immediate outlook, this means bond yields can still settle at a non-lethal level, and without causing collateral damage first.
From a portfolio perspective, however, this looks like a context that warrants shifting the focus to reducing and managing risk. The FNArena/Vested Equities All-Weather Model Portfolio is very much focused on quality, structural growth and reliable dividend payers, as most among you would be aware.
These are all categories negatively impacted by the recent rise in bond yields. Typically, as financial markets live "in the moment" and with human emotions switching between unbridled comfort and irrational fear, share prices are likely to weaken well beyond fundamental justification, just as upward trending market darlings are likely to end up in Wile E Coyote territory.
All this is why the All-Weather Model Portfolio this week raised its cash on the sidelines to circa 30%, as flagged on Monday.
To be continued next Monday.
Investors looking to play share market momentum in January might want to pay attention to some of the sector favourites that have been nominated by stockbroking analysts recently.
Inside the small cap automobile-related space, Citi repeated its preference for Bapcor ((BAP)) on Wednesday. UBS's most preferred insurers are Suncorp ((SUN)) first, then Insurance Australia Group ((IAG)). Plus UBS's most preferred exposures to building materials stocks in Australia are, in order of preference, James Hardie ((JHX)), then Boral ((BLD)), followed by Brickworks ((BKW)).
Commodity analysts at Goldman Sachs still hold six Buy ratings; BHP Group ((BHP)), South32 ((S32)) and mid-cappers Iluka Resources ((ILU)), Alumina Ltd ((AWC)), New Hope Corp ((NHC)) and Coronado Global Resources ((CRN)). Equally important, perhaps, is the team also has two stocks with a Sell rating: Iluka spin-off Deterra Royalties ((DRR)) and OZ Minerals ((OZL)).
Property sector specialists at Macquarie suggest investors should not expect any miracles from the Office space landlords; demand is weak, has been weak and is expected to remain weak for the foreseeable future. For investors looking for exposure, Macquarie prefers Charter Hall ((CHC)) and Mirvac Group ((MGR)).
Macquarie's consumer sector analysts continue to rate Woolworths ((WOW)) Outperform while preferring Harvey Norman ((HVN)) over JB Hi-Fi ((JBH)). Retail analysts at Credit Suisse remain convinced the market is still underestimating how much spending from households will flow towards discretionary retailers this year and next. Incidentally, this was also the view of analysts at UBS when they upgraded Super Retail Group ((SUL)) on Tuesday.
Credit Suisse predicts capital management will prove the next positive surprise, with each of Metcash ((MTS)), Harvey Norman and JB Hi-Fi seen as prime candidates to announce extra benefits for shareholders.
Noted: guardians of model portfolios at both Morgans and Morgan Stanley made no changes this month.
Extra observation: Market strategists at Morgan Stanley expect the ASX200 to trade in between the in-house base case and bull case projections for calendar year-end, which translates into index levels between 6700 and 7300.
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)
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