Make no mistake, rising bond yields are bad for assets
Right now, many investors are probably patting themselves on the back, having profited from a booming property market and the makings of a resurgent share market. But there is an elephant in the room – rising bond yields. And they could bring the party to an abrupt end.
Let’s take a quick look at the portfolio of a typical investor. There’ll be some shares for growth, some fixed interest, hybrids or infrastructure stocks for income and some property for diversification. So which of these are at risk from the rising bond yields we have been warning investors about all year?
The answer is: all of them!
Interest rates act like gravity on the value of assets. The higher the interest rates go, the greater the gravitational impact on asset prices. Irrespective of whether we are talking about bonds, shares, farmland or businesses, all assets are worth less when interest rates rise.
And bond rates are rising.
I have made this observation before but it remains a wonderful confirmation of the faddish nature of investor character; during the turn of the century tech boom, anyone investing in low-growth, high dividend yielding stocks, in boring industries such as infrastructure, were regarded as a boring has-been. In fact, in 1999 Warren Buffett was no longer described as the ‘Oracle of Omaha’, he was a pariah, like many who missed the tech boom. He had failed to see how the internet would change the world and was ‘washed up’.
In the most recent boom however it was precisely those same ‘washed up’ stocks that investors couldn’t get enough of. Forced by low returns on cash deposits investors stampeded into ‘higher’ yielding shares unwittingly taking on equity market risk for mere bond-like returns. But ignorance is bliss and the trend became self-reinforcing as rising share prices communicated to investors that they were ‘right’ – the upward price move was an affirming wind at investors’ backs.
As shares were pushed higher, by the baby-boomer-fuelled migration, the most expensive stocks became those of companies with the highest dividend payout ratios. Higher dividend payout ratios however mean lower retained earnings for growth. The most expensive companies then were those with the lowest self-funded growth.
Another group of companies that became expensive were those that the weighted average cost of capital calculation favoured. The formula valued most highly those companies that were 100% funded by debt. When low interest rates raise the values of companies with the most debt, something is seriously awry.
And so, since 2015 we have been warning investors that the chase for yield was a fad with dire consequences when the fashion changes. Low interest rates were corrupting their sense of risk and this was being reflected in the fact that the most expensive stocks were those with the most debt or the lowest growth.
Thank Donald Trump for the snap back to reality. Bond rates that were already rising since June spiked quickly, precisely as we warned. Back in 1994, bond rates rose 200 basis points in just a few weeks. Unsurprisingly, Sydney Airports – geographically located on a vacant block at the end of a global cul-de-sac – has been slammed. Transurban, the operator of the cul-de-sac, has also been slammed, REITs and utility stocks have also been hammered.
So where will it end? It won’t. Those commentators who believed low and even negative interest rates would stick around for a long time, labelling the era ‘the new normal’, were unwittingly succumbing to the same ‘this time is different’ groupthink that suckered in the technology investing bunnies of 1999 and 2000.
Debt is at record highs in Australia – not good as bond rates start to climb by the way! Mortgage debt as a percentage of both income and GDP is at a record, credit card debt is also at a record and government debt will also expand – as Colin Barnett in WA has found out over the last eight years with the debt in that state rising from $3.6 billion to $27 billion. And companies that borrowed heavily to buy back shares, pay special dividends or pay for overpriced acquisitions will find their profligate ways coming home to roost.
All this while aggregate P/E ratios for the ASX200-ex banks and the S&P500 remain at, or near, historic highs.
And whether they know it or not, ‘investors’ (I use the adjective loosely) who geared up to buy apartments for their kids amid a frenzy-inducing fear of missing out, are facing an abyss and are about to do their dough. I hope they don’t blame their kids. Make no mistake, rising bond yields are bad for assets.
And don’t take encouragement from the fact that stock markets have risen since Trump’s election. It has always been the case that during the early stages of rising interest rates, the stock market goes up. It does this because investors are buoyed by expectations of economic growth. History also shows us however that the enthusiasm ends as continued rising rates on bonds and cash become more attractive than riskier assets.
Our solution over the last six months has been to raise cash to take advantage of inevitably lower prices. We have also focused on companies able to grow their earnings. Rising interest rates will have a negative impact on the ‘P’ in the P/E ratio so you need a compensatory boost to the ‘E’ in the same ratio. And separately, we have also launched alternative funds such as a market-neutral and a long/short fund offering return profiles that are uncorrelated with the other asset classes. The timing is not coincidental.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Brett Edgerton
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Yes things have gotten interesting. In my opinion it all remains to be seen whether the Trump presidency is akin to the Whitlam prime ministership – in terms of policy urgency if not policy intent – or he turns out to be rather more “pragmatic” (as the herd currently like to call it).
It’s interesting how the world turns. I had been slowly developing the view of artificial stability in markets for a prolonged period that was well articulated by Jeremy Grantham and Ben Inker in the GMO 3Q2016 Newsletter – and feel sure that a Clinton election would have continued the status quo for a good while longer.
But now we have completely black box in the form of Trump and we are presented with a matrix that runs from extreme policy urgency/radical policy initiatives right through to pragmatic policy urgency and initiatives (so no much deviation from the status quo). And if anybody pretends to have a good handle on where this presidency will go then one should promptly disregard all that they say.
Absolutely the unexpected election of Trump has thrown market psychology on its head, and has the capacity to kickstart a return to the cyclical boom bust (revert to mean) world that we have come to know and love over the last half century (Grantham reckons we have been spoilt with around half of all speculative bubbles from the last 400 years occurring in that period).
But given the remaining imbalances in the world – and especially public and private debt – and thus the need for central banks to continue with extraordinary policy accommodation (afterall the Fed Fund rate is still well below 1%), one has to consider that the likelihood that this is a false dawn is non-trivial and in fact is probably significant.
While I would not be surprised if the peak for bond prices has been seen, I would be equally unsurprised if there were very significant retracements in these recent moves for several years ahead…
Alan George
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Hi Roger – everyone seems to think bond yields are going a lot higher but if you look at the charts 10 year US treasury bonds have been in a downward channel since 1988 with movements of 50-60bps quite common and at times the yields have hit 3%. There are a lot of deflationary forces at play – retirement of baby boomers, underemployment, growing welfare, automation, slowing productivity, shrinking middle classes and massive private and public debt. As far as I can see stimulus packages such as QE have failed to stimulate consumption and basically have kicked the can down the road.
jimbo james
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Good point about the mainstream press Luke. Unsighted on the ‘bondcano’! This is not unexpected of course when you consider for example, the contribution of the property industry to businesses such as Fairfax. Spooking the horses is not on the agenda and a mass of investors suddenly looking for the exits is to be avoided at all costs. Paradoxically, for the property industry it might actually be their saviour to pick up a few more listings as the crew at McGrath might attest to.
Andrew
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Hi Roger, how do you believe the RBA will balance the anemic domestic economic growth rate and the upward pressure on global interest rates. Do you think the Australian economy would stall if the major four banks were to raise interest rates?
Roger Montgomery
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There;s a lot of debt around mate. And all bets for growth are backing a continuation of the residential construction boom.
Max Zan
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Hi Roger
What you say makes sense , but your comments in the last paragraph leads me to conclude that in the “short term ” you expect your funds to struggle and the best that can be expexted is to minimize losses by employing those strategies. There is nothing wrong with that, but where is the incentive for existing and new investors to remain or place funds with you in the “short term” ?
I know you are not a fan of the Listed Investment Company structure , but it appears that at this time a LIC addition to your Funds would make it attractive for new and existing investors – you could sit on the cash until the opportunities presented themselves. I don’t see that you would have trouble raising a substantial amount to make it worthwhile. A closed end structure such as a LIC has many advantages over a managed fund both for the Manager and the Investor – I’m not going to talk about those here as you know what I mean.
What do you think?
Roger Montgomery
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No LIC Max. I have previously listed a LIC and been its Chairman. I currently have no intention of listing another nor of being distracted by being listed.
Luke Fennell
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Hi Roger – another salient warning on the effects of a rise in bond rates. For some time I have been asking those I know who are concerned about various large political/economic issues to go and read for just one hour about the bond market situation and tell me which of their other issues seems larger. Most are shocked that this situation has more or less gone ‘under the radar’ of the mainstream press . Your comment about the faddish nature of investor character I think is ‘on the money’ and I predict that in two years from now there will be endless stories about the bond market, all long after the effects are felt.