A bond market reminder of market fragility
The recent fall in US long-dated bond prices was a good reminder of what might happen if interest rates steadily rise from here.
From September 2020 to March 2021 the US long-dated bond market suffered one of its worse ever periods of decline. The iShares 20+ Bond ETF dropped 20%. This happened because just 1% was added to long-dated bond yields. It is a good reminder that in this low interest rate environment small increases in interest rates have a dramatic impact on asset valuations.
Equity prices have not reacted to this reminder, but they are just as susceptible to increasing interest rates as the bond market. The chart below shows how interest rates impact the valuation of a company. A basic metric for valuing a company is its PE ratio, its share price divided by its earnings. This metric indicates that equity prices are historically high. However, these high prices can be justified if you believe interest rates will remain low. This is because the value of future cash flows increases as interest rates fall.
However, if interest rates rise the cost of capital will increase, and this will reduce the value today of those future cash flows. The table below makes some simple assumptions to simulate the effect that rising interest rates can have on equity prices. We assume a PE ratio of 20x is justifiable at a Cost of Capital of 9% and a growth rate of 2%. The table then shows how the value of those cash flows falls as interest rates increase.
Whether interest rates keep rising will have a lot to do with the inflation outlook. If Reserve Banks across the globe become concerned that inflation is out of control they will raise interest rates. The current inflation spike is beginning to look a bit less transitory, but market consensus continues to assume inflation will ultimately fall away. Inflation becomes persistent when employees start expecting regular wage increases. There are signs of that. There has been regular reporting in New Zealand and abroad of labour shortages, and of an increased appetite of employees to consider an employment change, being dubbed the “Great Resignation”.
A recent survey by McKinsey found that forty percent of employees surveyed in Australia, Canada, Singapore, the United Kingdom, and the United States were at least somewhat likely to quit in the next three to six months. They also found that most employers were experiencing greater turnover than normal and most expected the problem to continue or worsen over the next six months. There appear to be many reasons for this, but primarily employees must see themselves in a strong bargaining position. This has not been the case for a long time.
If interest rates continue to rise, there will be plenty of investments to avoid. Traditional balanced funds look vulnerable, in our opinion, because of their high exposure to low yielding bonds. There will also be plenty of blow-ups. Risk-parity and volatility targeting strategies are, in our opinion, ones to watch here. In a traditional balanced strategy you increase your expected return by increasing your exposure to growth assets, predominantly equities. As a result, the higher your expected return, the higher your exposure to equity risk. The goal of risk parity is to build a diversified portfolio where each group of assets contributes an equal amount of risk so that the return is not primarily determined by equities. However, these strategies are essentially leveraged bond portfolios with some equities. And imprudent leverage can result in permanent loss of capital, even if the underlying asset is relatively safe. There is a lot of money invested in these strategies. Estimates vary, but total assets under management in strategies that respond to risk inputs could be over 1.5 trillion US dollars.
Our economic future is still very much up to the policy makers. Where inflation and interest rates might go remains highly uncertain. But expect some bumps along the road, and, as the recent bond drawdown showed, some of them will be big ones.
Stephen has over 25 yrs investment experience & co-founded Castle Point, a NZ boutique fund manager, in 2013. Prior to that he worked at funds management companies in Auckland, London & Edinburgh. Castle Point WINNER FundSource Boutique Manager 2019