Investors’ Corner | Wednesday, 16th February 2022

Regime Change: as interest rates go up, investors will need to adjust portfolios

• Headline and core inflation is higher than central banks thought it would be
• A new interest cycle is starting that markets are not positioned for
• Asset bubbles will deflate with long duration / zero-to-little yield / highest-multiple assets most affected

What might the solution be?

Sub-ordinated debt of financials (characterised by healthy yield and low duration) and financial equities (characterised by high yields and potential for decent capital appreciation).

In our January post, we waved the inflation flag as the US had just printed a 7% inflation number, Germany was hardly lagging with 5.7% and the Eurozone only marginally behind. Inflation had become a problem and central bankers were being exposed.

So, what has changed in the last four weeks? Essentially, no less than regime change. Markets are reacting to the start of a hiking interest rate cycle. Equity markets are down YTD (S&P 500 -8% and Europe’s Stoxx 600 -5%), yields are up (US 10-year yield bond is up 30% YTD to ~2%). Central bankers have become significantly more hawkish and started the process of a tightening cycle. The BoE has acted, the Fed has taken its tracksuit off and is in the starting blocks and the ECB has woken up, slightly surprised and has been reluctantly putting on its clothes and organized a meeting to see if it should change its mind.

Over the last several years, almost a quarter of the bond market has been yielding negative rates. That has now changed. Yields across the board have gone up. The German 10-year bond, the Bund, went from negative to positive 20bps over the last three weeks. That is a big move and represents a massive change in market sentiment. Negative rates have ended, and the ECB will need to catch-up with its policy rates.

What do investors need to be aware of? The market is pricing in the following for interest rates (i.e. forward curves). In Europe we are currently at -50bps, in the UK base rates are +50bps and in the US we are at zero. By the end of this year, the market is pricing in European interest rates up to 0%, a 50bps increase, the UK to go to 1.77% (a 130bps increase) and a similar 140bps increase in the US. The Fed is likely to raise rates in March for the first time this cycle and will continue raising rates at most meetings this year. The UK is already up and running, and the ECB has decided to wait until new macro estimates are produced for the March meeting before acting. If the ECB is ever going to get out of its extreme policy stance, it needs to start at some point.

What does all this mean for markets? The US 10-yr has gone from its 2020 lows of 50bps and has recently surged to 2%. That puts it at the same levels it was just before the pandemic started. Looking five to six years before that, the level of 2.25% – 2.50% then would seem reasonable now and reflects our current target range. If that is the case, one could say the market has already priced in 70%+ of the adjustment / tightening in this cycle. However, there is a conflict. Most investors have not meaningfully adjusted their portfolios and although there is ‘only’ 30% of the adjustment to go, clients will feel they have to act / de-risk given the increased uncertainty in their minds. The main reactions by investors will be to reduce duration and exposure to the lowest yielding assets. Interestingly, sub-ordinated financial debt currently yields 4%, with approximately half the duration of the overall bond market, representing a sensible alternative that is, at the very least, higher than core inflation.

In equity markets, the Nasdaq is down 11% YTD and the main equity indices have slipped from their peaks. Higher interest rates are not necessarily bad for equity markets but there are a few points to note. Higher interest rates tend to depress both earnings and valuation multiples, so equity markets are likely to struggle over the next few years. A policy mistake, or a large slowdown in growth would create a negative backdrop. For those companies that have high multiples and optimistic forecasts, there is likely to be a reality check. Stock markets peaking, macro headwinds and policy turning have some parallels with 2000-2001. At that time, we saw the Nasdaq fall close to 60% over 14 months but US and European bank equity rallied 19%-37%; see below.

Although we have no strong view over where the Nasdaq might go from current levels, European banks need to rally ~100% just to bring their current >6% dividend yield down to its 25-year average. Notably, that is not a completely wild statement. Every other asset is yielding significantly below its 25-year average. Banks are likely to see earnings upgrades from higher rates of 10%-40%, which means dividends are likely to grow strongly over the next 3+ years. It looks like banks are about to have their time in the sun over the next several years. Bank equity, bank sub-ordinated debt, or a combination of both are a good hedge for the current market backdrop.