Chips with everything
What happens to long-term yields is hugely important to fixed income investors, asset-liability managers and asset valuations in general. However, I sense a bit of hysteria at the moment. Yields have moved higher because there is a “reflation” mind-set in markets driven by expectations of growth and greater tolerance of inflation by our central banks. In my mind, yields are a long way off causing damage to growth or the equity market outlook. Earnings are growing and secular themes are driving returns. However, complacency is dangerous. Headline inflation could firm up in the coming months and bond investors may get spooked. The Fed needs to reassure markets that it is on top of things. The message has to be that inflation would have to be higher for longer to upset the monetary policy apple cart. Meanwhile, buy semiconductors!
Yields: a concern?
Two key cyclical drivers of markets and investor sentiment are long-term interest rates and earnings growth. In recent months the evolution of both has supported the “reflation” theme. The modest steepening of the US Treasury curve and the better than expected run of corporate earnings reports have, so far, been positive for risk-assets. However, there is more and more talk about inflation and concerns that long-term interest rates could reach a level at which they become a negative for credit and equities. There is no magic number of course. I can’t sit here and write that a 10-year US Treasury yield of 1.5% is where you should start to de-risk. Yet the Treasury yield is probably the most watched financial indicator in the markets. It represents the future of real interest rates and inflation, and is also used to infer what markets think about growth and the trajectory of government debt. As such it pays to think about what is driving higher yields and what that means for other assets.
Earnings are growing
Excluding the period of market turmoil as the world went into lockdown last March, the lowest print for the benchmark US Treasury 10-year yield was 0.5019% on 6 August last year. It has since risen to 1.515%. The 7-10-year US Treasury bond index delivered a -3.33% total return over that period while the S&P500 total return was 17.8%. So quite a big increase in long-term rates did nothing to undermine equity market performance. Based on the IBES consensus 12-month forward earnings estimate, the earnings yield for the S&P was 4.46% at the beginning of August, which was 3.95% higher than the Treasury yield. That gap has fallen slightly to 3.25%. Hardly an earth shattering shift in relative valuations. While averages don’t say a lot, the PE on the S&P500 based on 12-months forward earnings has remained remarkably stable at between 22x and 23x over the last six months. The 12-months forward earnings estimate has risen by 11.6% over that period. Bond yields may have gone up, but equity yields have held in due to the strength of earnings momentum.
Yields: driven by inflation
It’s informative to look at what has driven the rise in yields. Back in August the real 10-year yield was -1.09%. The 10-year inflation break-even was 1.62%. Today, the real yield is more or less unchanged at -1.06% while the break-even inflation rate has risen to 2.2%. All of the increase in nominal yields has been driven by the rise in market inflation expectations. In Europe, the German real yield (based on the 0.5% 2030 inflation-linked German government bond) was at -1.37% at the beginning of August and is now 21 basis points lower at -1.58%. Over the same period the break-even inflation rate has risen from 0.8% to 1.05%. Bond markets have priced in higher inflation. The interpretation is yours, but I would suggest that this reflects the combination of a shift in the range of inflation outcomes (markets no longer put as much probability on deflation) coming from expectations of a strong post-COVID growth surge, and from the messages from central banks. Since last summer central banks have reinforced their commitment to not changing their monetary stance until inflation is higher.
Central banks keep real yields low
What bond markets have not displayed yet is any concern about the rise in government borrowing that has accompanied more aggressive fiscal policies. If “bond vigilantes” (is that even a thing?) were worried about the debt stability, real yields would be much higher. The fact is that central banks continue to buy government bonds. The Federal Reserve holds around 34% of outstanding marketable US Treasury notes and bonds. It keeps buying. The ECB, Bank of England and Bank of Japan, amongst many others, own huge amounts of their domestic government debt market. Thus when governments borrow, the net amount of outstanding debt held by the public rises by less than the issued amount. At the same time, demand for risk-free long duration assets remains strong.
Some upward risk
The current 5-year/5-year inflation break-even for the US is at 2.38%. That would be more or less consistent with the Fed’s average inflation target. Yet this week the headline inflation rate reported for January was just 1.4%. The next few months will be interesting. Forecasting the US inflation rate on the basis that the monthly increases for the rest of this year will be close to the pattern of average monthly increases over the last 10 years suggests that the headline rate of consumer price inflation will jump to close to 3% in Q2. Base effects and the recent rise in oil prices are factors. The Fed and economists will tell markets to look through this “blip” higher, but the bond market might display a sensitive trigger finger. Break-evens could move higher, pushing the 10-year yield above 1.5%. If “taper” talk takes hold, the move could be even bigger.
Lessons learned from 2013?
However, the Fed is not stupid. It knows what happened in 2013. The 10-year yield rose by 140bps between May and September on the view that the Fed would scale back its asset purchases. Back then the Fed only held about 20% of outstanding marketable Treasury securities compared to 34% today. Yields went higher, credit spreads widened, and the equity market had a 6% set-back between May and June. Evidence from Fed-speak suggests that they are well prepared to push-back on any market expectations of taper talk. After the rise in yields in 2013, it wasn’t until the beginning of 2015 that yields had returned to their pre-tantrum levels. A period of higher long-term yields when there are uncertainties in the outlook is not what the Fed would want.
Not a problem yet
Let’s assume that there is a modest further increase in yields driven by even higher inflation expectations and optimism on growth. Say the 10-year reached 1.5% by mid-year. On the basis of the current earnings consensus, the earnings yield would be around 3.1% higher than the Treasury yield. Stocks might lose a little of their valuation attraction, but I really think yields would need to be much higher to derail the equity bull market. If there is no growth in earnings and yields are higher, that would be negative for equities given that valuations would be impacted by the higher discount rate. But there is growth and the Q4 results have brought healthy upside surprises. Year-over-year growth in earnings has turned positive.
Multiple themes in equities
Higher yields might have some impact on parts of the equity market, however. The rule of thumb suggests that higher yields and a steeper curve benefits cyclical value equities at the expense of longer-duration growth stocks. So far in 2021, growth is slightly beating value so the rise in yields has not had too much of an impact on rotation in the market. What I find really interesting is that the stock market is being driven by all kinds of themes, not just the traditional macro signals. Some of them are concerning as they suggest a level of frothiness in valuations (SPACS, retail trading, social media IPOs etc). Others, however, reflect longer-term structural themes. The energy transition is a major one and is having an impact on stock performance today.
This week, President Biden signed his “Buy American” executive order. As part of this he pledged to replace the entire Federal government’s vehicle fleet with electric cars and trucks, all to be made in America. According to one article I read, citing the General Services Administration, the Federal fleet consisted of 650,000 vehicles in 2019, split between the military and civilian agencies. That’s a lot of EVs to produce. Electronic vehicles are big drivers of demand for semi-conductors and there is a massive shortage of chip capacity currently. Demand for electric battery capacity is also sky-rocketing and with it demand for cobalt, a key input into the manufacturing process of batteries. The price of the LME’s spot cobalt contract has jumped by over 40% since the beginning of the year. In related news, one of the biggest Chinese producers of polysilicon, the material used to convert sunlight to solar energy, has announced a huge investment to expand capacity. Solar power is part of the value chain in producing green hydrogen – another booming sector – and some of Biden’s Federal fleet might be powered by that fuel technology. Share prices of leading polysilicon producers have been rising strongly, as have those of semiconductor producers and companies involved in the supply chain for electronic batteries. While many people focus on the FAANGS as being the main story behind the rise in stock markets, the acceleration of the energy transition is proving to be a major force behind rising equity prices elsewhere.
Cyclical versus secular
Treasury yields might go up more and this will undercut returns from fixed income strategies. But I doubt we are about to see a multi-year bond bear market. If they go up and things start to wobble, then go long duration because they will come down again. What is more important for long-term investors is not missing out on the secular themes. We are rapidly shifting to a lower carbon environment; electronic vehicle growth is huge, and the zero carbon and digital themes intersect on many levels. The world is hugely short technology (as the mixed quality of broadband connections in our zoom-meeting world has demonstrated) and renewable energy (only 2.7% of all new UK car registrations in 2019 were classed as Ultra Low Emissions Vehicles) and will be for years.
All data sourced as of 5th February 2021
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