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A little more than one year ago, on the 11th of March, the World Health Organization (WHO) officially declared the coronavirus outbreak a pandemic, as COVID cases outside China had increased more than tenfold in the preceding two weeks. That same day, the Italian government had no choice but to announce the toughest lockdown yet seen on the European continent, and with a renewed outbreak related to the British variant of COVID 19, Italy prepares for a third (Easter) confinement as we speak.
Hard to believe a year has passed since the lockdowns first began. The rollercoaster that ensued and the measures taken on the fiscal, monetary and sanitary front have been of unseen proportions and one can definitely wonder how all this has been able to ‘fit’ in just one year. Visibly, equity markets have experienced a wild ride as well, going from a waterfall crash for the bigger part of March 2020, to a gradual healing process following monumental monetary and fiscal life support measures, with the ‘watershed’ moment being the Fed’s unlimited QE announcement on the 23th of March. A third phase in the equity market trajectory was kick-started in November by the successive announcements of two effective vaccines and subsequently by market participants looking through the lockdowns and pricing in the re-opening of our economies.
While most economic regional blocks have been reluctant to implement further fiscal measures, the newly installed US government has pushed through two additional, vast fiscal plans, with a large infrastructure bill still in the pipeline. This fiscal largesse, coupled with the likely unleashing of excess personal savings post-lockdowns and good US inoculation traction (unlike in the EU), has propelled US 10-year rates higher with a remarkable acceleration in US 10-year real rates since mid-February. Ten-year nominal rates have doubled since the start of this third phase and have pierced through the pre-COVID level of 1.5%, surpassing the average dividend yield of the S&P500 Index.
Putting aside technical elements such as the impact of convexity hedging in the mortgage-backed securities (MBS) market or uncertainty related to the extension of the supplementary leverage ratio (SLR) for US banks, the rise in nominal rates can be decomposed into a reflationary phase (characterized by a gradual ascent in break-evens) and a subsequent phase where market participants have started to discount a ‘high pressure’ US economy. This latter sub-phase is characterized by surging real rates, is reflective of better growth prospects, but is also (potentially) indicative of growing unease among market participants about the ability of fiscal and monetary bodies to continue to work in tandem. This, despite the fact that the Fed has clearly communicated about its Flexible Average Inflation Target (FAIT) framework with an emphasis on looking at incoming and not prospective data, and thus setting aside transitory inflationary pressures. Strategists seem to be mesmerized about a single item, i.e. the US 10-year rate. Specifically, they seem to wonder about its current and future trajectory and the impact for their positioning as equity investors. US rates are a top preoccupation, even for novice pundits, and have clearly taken center stage over the last couple of weeks.
For now, equity markets have shrugged off the rates upheaval, as financial conditions have not tightened, inflationary prints remain well contained and real rates remain comfortably in negative territory. On top, companies on both sides of the Atlantic have reported impressive Q4 earnings. For the moment, stellar growth and earnings prospects dwarf the headwind from a higher discount rate on equity multiples (except for excessively valued stocks). However, under the surface, market repositioning has been frenetic and unfortunately this has been symptomatic and repetitive behavior over the last year. Equity market participants seem compelled to invest in either growth or value style factors (with very little middle ground), have investment horizons that apparently reach no further than 6 months (we would point out the vivid appetite to suddenly ‘play’ the re-opening beneficiaries, just after the vaccine news came out) and are hooked on the actions and words of central bankers.. this all being conducive to erratic and volatile stock market behavior. Making things worse, are the dominance of ETF’s (active or passive) or CTA’s, increased leveraged and speculative trading and bouts of positive correlations between bonds and equities over the last couple of weeks.
As already extensively explained by CIO fixed income Peter De Coensel in his excellent piece QE² the days of a well-contained volatility index are long gone and therefore we should get accustomed to structurally higher volatility levels. And hence we should not model structurally lower equity risk premia (ERP), another key determinant when computing discount rates (besides long-term real rates). The strong equity market resilience we have observed till now could be severely tested in case of further bond market turmoil.
Although we are not a big fan of putting companies in style buckets, the outperformance of shorter duration or value equity assets over the last couple of weeks is noteworthy and somehow illustrative of the fixation on long-term rates (see graph below).
MSCI World Growth vs World Value since Vaccine news
Granted, some form of “market purging” of companies whose streams of FCF generation are projected far away into the future was long overdue and a welcome development (by central banks as well), while some value-tilted sectors will profit disproportionally – although this is already well discounted — from a cyclical upturn and suffer less from a higher discount rate. But we are not particularly in favor of overly focusing on macro drivers such as interest rates or inflation in order to invest with conviction into structurally growing trends and to construct robust portfolios.
Let’s take real estate as an example. Traditionally, the overall real estate sector has profited from rising inflation through increased rents, as contracts are usually CPI-linked. The condition for this mechanism to be preserved in a sustainable way is for the landlord to keep its pricing power over the long haul. In some subsectors of real estate such as shopping centers or office buildings, the balance of power between landlords and tenants has started to shift in favor of the latter and has even accelerated with COVID.
Only the best assets in these ailing subcategories of real estate will maintain their inflation hedge status. Hence making straightforward conclusions from rising inflation for a typical inflation beneficiary is not as obvious as it might first seem. From a balance sheet perspective, rising rates can cause havoc to the portfolio of a landlord (e.g. breach of covenants, forced asset sale), especially if the underlying assets are low yielding and exhibit high loan-to-value ratios. Selectivity and conviction are again instrumental in order to make sound investment decisions. Looking at the current market backdrop, we would note that pockets of ‘value’ start to emerge in the so-called bond proxy category such as listed real estate, utilities, staples or big pharma.
Even if interest rates can be a determining top-down driver of the future trajectory of a particular (sub)sector, one needs to take into account other top-down material drivers that can dwarf interest rate dynamics. Often, disruptive forces are underestimated in this top-down analysis. What matters in the long run is a company or subsector’s actual ability to compound (i.e. the USP/Unique Selling Proposition” of equity investing) and create shareholder value, not the investing public’s fickle opinion about prospects in the short run. Moreover, longevity of value creation is often underestimated by market participants and thus a source of market inefficiency. Typically, the opposite is valid for shorter duration assets, i.e. an overrating of the durability of cash flow generation. Provided they are bought at reasonable valuation multiples, compounding (or longer duration) companies have the inherent qualities to outperform over the long term. Additionally, they better withstand inflation due to their better pricing power and higher margin levels, while managing their business with lower leverage.
In order to navigate portfolios in different market circumstances, and mindful of the stock markets’ past wild moves, we take into account elements such as liquidity, inflation or interest rate sensitivity at the portfolio level (e.g. envisage more ‘quality value’ ideas or avoid ‘concept’ stocks), as they can enhance its robustness. A barbell approach of companies with “sound growth at a reasonable price” and of “cheap but not broken business models” is key in the portfolio construction process, at all times.