Global outlook
Donough Kilmurray
Chief Investment Officer
Do rising rates lift all boats?
This time last year, as inflation and interest rates spiked, we were stuck in a bear market for stocks and facing the worst year for bonds in modern financial history. Economic models were flashing red for recession, driven by energy prices and interest rates. A year on, the world has changed, and investors are facing an unexpected and unfamiliar landscape.
First, the recession never came, most notably not in the US, the world’s largest economy. Europe came very close, dragged down by Germany. The UK surprised by avoiding a collapse and even revised its data recently to show a better COVID-19 period than previously thought. However inflation still lingers, the economic data is getting weaker, and higher rates may yet take their toll.
TINA becomes TARA
As tempting as it is to try to time the economic cycle, a more useful exercise for investors is to figure out what higher interest rates mean for multi-year investment returns. From the GFC (global financial crisis) through to the COVID-19 period, central banks kept interest rates and bond yields close to zero to stimulate the economy. In this low-growth low-rate world, markets bought into the mantra of TINA (There Is No Alternative) and equities were the runaway winner.
Now from the pain of 2022 has emerged a new world of TARA (There Are Reasonable Alternatives). High-quality government bonds are at yields not seen since before the GFC, and corporate bonds yield even more. With the global economy avoiding recession and artificial intelligence (AI) raising expectations for growth, stocks are still going strong. On the face of it, investors have a much better set of choices now, but it’s reasonable to assume that higher rates can still hurt asset prices.
Bonds - never say never
2022 was a traumatic time for bond investors. Now in late 2023 yields have mostly adjusted to the new environment, and sentiment falls into two camps – a cautious group that is so scarred by last year’s losses that they never want to own bonds again, and another group who wonders why should they bother with anything else now that returns of 4% (in EUR) or 5% (in GBP) are easily available (as of 30th September). The allocation question is further complicated by the unusual shape of the bond yield curve.
For the first group, it’s worth remembering why we own bonds in the first place. High-quality bonds are a lower risk asset that usually brings stability and balance to a portfolio. They act as a hedge against recession and deflation, and ideally, they provide an income. All these historical reasons are still relevant today, and income in particular is more relevant than it has been for some time.
The lingering doubt is whether unexpected inflation, which is like kryptonite for bonds, will continue to dog the asset class. It’s not unreasonable to imagine that inflation uncertainty will continue to disrupt bonds’ balancing relationship (aka negative correlation) with stocks for much of this decade. However, it’s worth noting that, unlike in 2022, bonds now have a yield cushion to soften the blow should further inflation cause central banks to raise rates again.
In our discretionary portfolios, we have been underweight bonds versus long-term target levels for years. Late last year we began gradually restoring our bond allocation, and we are almost back to our neutral or strategic levels. Not because we are predicting a recession, but because bonds are now ready to play a more effective role in portfolios again.
Figure 1: USD bond yields now and before COVID-19
Source: Bloomberg, as at 30th September 2023
Figure 2: EUR bond yields now and before COVID-19
Source: Bloomberg, as at 30th September 2023
A short-term or long-term relationship?
Given what happened last year, and with so much uncertainty around inflation and rates, it’s not a surprise that many investors are choosing to park their capital in short-term bonds. Yield curves are inverted, meaning that investors are being paid more to own shorter-term bonds than longer-term bonds. With 3-4% available in EUR, or over 5% in GBP, from high-quality low-risk assets, short-term bonds seem like a sensible investment strategy.
For liquidity capital or investors with a short time horizon, such bonds do indeed make a lot of sense. But longer term investors should not confuse yields with returns. If you buy a 1 or 2-year bond now, your return will be the yield of the bond, assuming you hold to maturity and it doesn’t default. When the bond matures this return is no longer available beyond that point.
Central banks have made clear that interest rates are being held above their natural levels to quash inflation, and that they will relax once this job is done. While we know neither the timing nor the neutral level, rates will likely be coming down later in 2024 or 2025. The capital gains on mid-to long-term bonds should be comfortably higher than the current yield advantage of short-term bonds, meaning that investors are better off staying at least medium-term in duration.
Some investors are looking at the yield curve and choosing to take this idea further. For example, a long-term UK investor could now buy a 5-10 year corporate bond portfolio for ~5.5% yield in GBP. While this makes more sense than owning short-term bonds, an investor with a 5-10 year horizon would achieve a better risk-return profile by adding equities to their portfolio.
Do higher yields mean lower equity valuations?
What made 2022 doubly painful was the damage that higher rates did to both defensive and growth assets. The impact on bonds is mechanical – higher yields mean lower prices, and vice versa – but the relationship with stocks is more complicated. A famous chart circulated throughout the industry showing how lower real yields (cheaper money) coincided with higher equity valuations during the COVID-19 recovery, implying that higher yields meant lower valuations.
Figure 3: US equity valuation versus real bond yield (2018 - 2023)
Source: Bloomberg as at 30th September 2023
This chart neatly fits the narrative from 2018 to 2022, but reality started to go another way in 2023. Is the market valuation wrong, pumped up by AI stocks, or was the relationship not real? Looking back further in time, we find the relationship between yields and valuations is weaker than recent history suggests. Growth and expectations are more important for earnings and valuations, and the global economy and corporate earnings have held up much better than expected in 2023.
Figure 4: US equity valuation vs. real bond yield (1992 - 2023)
Source: Bloomberg as at 30th September 2023
Of course, higher yields mean higher financing costs for businesses and households, and this will slow growth. More so in Europe, where we finance more via variable-rate bank lending than in the US, where cash levels are still high and mortgages and corporate bonds are at long-term fixed-rates. This doesn’t mean that US equities are immune to higher rates, but the impact is not immediate. For example, the economy is softening, and yet earnings forecasts for 2024 are quite positive.
Where does it hurt?
If higher yields have made bonds more attractive, and haven’t hurt stocks as much as expected, does that mean investors can relax? Unfortunately not. The solution to the credit crisis of 2008 was even more debt, and a decade of super-low rates encouraged more borrowing throughout the system. Any asset that relies on variable-rate borrowing is now vulnerable.
The obvious place to look for leverage is real estate. In residential property, Europe (including the UK) is far more exposed than the US due to the dominance of variable or short-term fixed mortgages. Constrained supply, the bane of buyers, is preventing a market collapse. Commercial property is funded more by shorter-term fixed debt, and here there is a significant risk of price decline, as cap rates should adjust upwards to reflect higher yields.
Much of the private asset world has long relied on leverage to engineer greater capital efficiency and higher returns. It is noticeable that private equity activity has declined, partly due to uncertain public markets, and partly due to the increased cost of debt. Private debt and levered loan funds, which can now invest at higher yields, are going to have to work hard to protect capital and generate returns from existing investments.
Lastly, liquid alternatives, including hedge fund strategies and commodities futures, are benefitting from higher rates as their underlying capital is held in cash or bonds. However, they both face greater competition now from bonds in the minds of multi-asset investors.
A brave new world
In summary, higher interest rates mean that investors have a different range of choices this decade. Cash and bonds are firmly back in the conversation, although inflation will likely be more corrosive. Slower growth and higher uncertainty should constrain equity earnings and valuations, which are generally modest outside of certain US sectors. This means that while we’re unlikely to see a repeat of the 2010s, this should not be a repeat of the 2000s either, which was a lost decade for equity investors. Just beware of any assets that were built on variable-rate borrowing.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.
