The market is overreacting

In the month of March, global markets saw the rise in bond yields as investors worried about unmanageable inflation on the horizon. This has definitely shaken up global equity markets. And while inflation is a genuine concern that should be on the minds of investors, the market has overreacted. While we understand a cyclical economic upturn has just begun, we believe inflation will remain manageable in the short term.

In the video below, I explain why longer term, we have a high degree of confidence that the world will return to its low-growth, low-inflation, low-interest-rate environment. 

On the basis that we believe interest rates will remain structurally low over the long term, we are particularly excited about our investment in REA. There is no dispute that Australian residential property markets are rebounding strongly, supported by very low-interest rates in the context of an improving economy.

In the month of January, REA reported more than 128 million visits to realestate.com.au – an extraordinary feat, given a total Australian population of 25 million (including children).

And the long-term low-interest-rate environment also stands to benefit our alternative asset managers: Blackstone, KKR and Carlyle Group. Institutional investors are increasingly outsourcing their asset management to these major global platforms as the hunt for yield becomes challenging. This structural shift will drive very strong earnings growth for the world’s leading alternative asset managers for many years to come.

Whilst inflation is a concern for investors, we believe that with the US still grappling with the COVID-19 pandemic, unemployment and low interest rates, inflation is a manageable concern. Therefore, we are selecting the companies that have a runway of structural growth ahead of them. 

Edited transcript

What are your views on the recent surge in bond yields, which has caused some volatility in equity markets?

So, let me just take a step back and look at what's actually happening. We know that the global economy has just started to experience a meaningful cyclical economic rebound, and that will only continue throughout the course of this year and into next year as well as economies open up post-virus. We know that there's still plenty of stimulus about, both on the fiscal side and on the monetary side. So, that's created some degree of speculation that perhaps inflation will take hold and that's resulted in an uptick in bond yields. And so the chart that I've just shown here is a chart of the US 10-year government bond yield going back to about 2016.

You can see that 2016 to 2018 example where yields went up from 1.5% to 3%, and then more recently, yields have gone up from about 0.5% up to 1.5% over the last six months or so. That uptick in bond yields more recently has caused a bit of a stir in equity markets. We've seen some equity prices wobble a little bit. And the question of course is, is this the beginning of a real fly up in bond yields as a result of inflation, which is taking hold, or not? We certainly remain in the camp that that won't be the case. And as a result, we think that the market is really overreacting. Now, we could, of course, be wrong here, but let me tell you why we hold that view, and what I'll do is I'll break it up into a short-term view versus a long-term view.

Short term, it's almost as simple as there are still 10 million Americans out there who are looking for work who can't find it. There are 44 million Americans out there today who are still on food stamps and really struggling to make ends meet. These are not typically the types of conditions that result in really aggressive wage inflation. This analysis is also, for what it's worth, consistent with all the analysis we're seeing out of the major central banks, that the overwhelming consensus view is that this recovery still has a long way to go. So, that's the short-term perspective.

Longer-term, we really just take it back to thinking about some of these big long-term structural drivers, and we think about things like ageing populations, advances in automation, but really the big one is the degree to which governments are indebted, really as a result of funding all of these major fiscal stimulus packages. And that's really important. In our view, that's really going to place a lid on interest rates and stop them from increasing materially.

I'll just give you a simple thought experiment to illustrate this point. So, today, as a result of the gigantic fiscal programmes that the US has undertaken, their federal debt is about US$28 trillion.  Let's say the US 10-year yield increases from 0.5%, a few months ago, all the way up to 3%, right? So, that's an extra 2.5% interest rate, which, of course, drives up the borrowing costs for the federal government. Well, that's an extra US$700 billion that the federal government has to pay to service their debt that is otherwise not being used for fiscal spending.

So, all else being equal, taxes would have to be raised or spending would have to be cut. Both of these things are disinflationary. That's more than a three percentage point GDP negative fiscal stimulus each year for the rest of time. That alone would be enough to push the US back into recession, and frankly, the whole world back into recession. So, our argument, long term, irrespective of what happens in the short term, our argument is, we really struggle to see a world in which interest rates can remain higher for a sustained period of time, given that feedback loop it would have on all of the indebted governments out there who would have to service debt at much higher costs.

Then the final point I'd add is that if we use Japan as an example, the country has seen its interest rates falling from 8% down to zero over a period of 25 years. And I'm just showing that on the chart on the screen, there have been numerous instances over short periods of times where you've seen bond yields tick up sharply, whether it's 50 basis points, whether it's 100 basis points. It's happened a lot, but you zoom back out and the long-term structural trend in Japan, for a lot of the reasons that we've described, around ageing populations and increased government indebtedness, is really kind of a low-growth, low-interest-rate environment. And so that's where we think we're ultimately heading, notwithstanding the cyclical upturn that we're experiencing over the next 12 to 18 months and all the stimulus to go with it.

So, to summarise, interest rates aren't going to be a problem and will remain low for a very long time.

Yes, that's certainly our long-term view, for sure. And so that's why we think it makes sense to own some of the long-term winners, some of the long-term, high-quality growers out there, like Microsoft,  Alphabet,  Spotify and  Tencent, for example.

But you do also own some names that are benefiting from this short-term cyclical economic rebound?

Yes, we do have some exposure in the portfolio as well. So, names like Visa and MasterCard, still have a wonderful long-term growth story. Obviously, there's still a lot of cash and check transactions that can and will be shifted to cards over time. There's US$18 trillion of that transformation still to happen. So, that's a great long-term growth story, but short-term, they're really going to benefit from the cyclical rebound and particularly the opening up of travel and international tourism, given the extent of the cross-border transactions that are tied to that.

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Disclosure: Montaka owns shares in REA, Blackstone, KKR and Carlyle Group.