How Changing Interest Expectations Affect Asset Classes
Sam Morris, Investment Specialist, Fidante Partners
Central banks say inflation will stay low- markets have a different view.
During late 1993 and early 1994, the United States and global bond yields rose dramatically, collectively costing fixed income investors an estimated $US1.5 trillion in capital losses, as investors protested rising inflationary pressures and rising US cash rates.
US president Bill Clinton’s political adviser James Carville said at the time, "… if there was reincarnation … I would like to come back as the bond market. You can intimidate everybody”.
It was among the most violent moves in bond markets we have seen … until February 2021.
Fast forward to today, and we see similar circumstances – a record low cash rate[i], a global economy with an uncertain recovery path from a sharp recession, and markets fearful of the potential for rising inflation.
The key difference is how policymakers are responding, and the starting point of interest rates.
Back in 1994, governments and reserve banks were operating like a balanced see-saw, with the government in deficit stimulus spending mode and the central bank acting pre-emptively to head off the threat of rising inflation by raising short-term interest rates.
Today, record levels of government stimulus spending continue. Central banks say they are willing to tolerate higher inflation and lower-for-long interest rates to help return their economies to a post-COVID-19 normal while continuing to pump cash into fixed-income markets through quantitative easing programs (a form of monetary policy).
This combination of high fiscal and monetary stimulus occurring at the same time is viewed by markets as offering the potential for a return to inflationary conditions, which is resulting in significant volatility in fixed income and equity markets.
If you are age 30–40, that means every dollar you save today will lose around half its value by the time you need it for retirement – unless you invest it at a rate of return that exceeds inflation after tax.
The problem is that central banks are saying that inflation will remain low and there is no need to raise rates for several years. However, markets, put simply, do not believe them and are demanding higher yields that exceed expected inflation right now.
Impact of inflation expectations on returns
So how do changing interest rate and inflation expectations affect asset classes?
Interest rates play an important role in valuing the profits and income streams of equities. Higher interest rates “discount” the future profits of companies at a higher level, all things being equal, causing their current shares prices to be lower.
However, the impact is uneven, with growth companies like unprofitable technology stocks suffering greater “discounts” at present because their future profits are less certain and further away.
More cyclical “value” stocks have benefited as their profits are more near-term and positioned for an upswing in consumer sentiment and the credit cycle off a depressed base.
Real Assets (Australian Real Estate Investment Trusts, Infrastructure)
These assets have valuations that are often sensitive to interest-rate assumptions, hence often being referred to as “bond proxies”. Many have revenues that have explicit linkages to inflation and/or interest rates, meaning that these can adjust upward over time, but in the short-term, sharp upward movements in rates have hurt their values.
Another factor is debt: higher long-term rates increase the cost of borrowing for these assets, which are often quite leveraged, and this will play a role once refinancing is needed.
Finally, uncertainties over when consumers will start to shop (shopping centres), occupy offices again (office space) and travel normally (toll roads and airports) are a significant swing factor in the future return outlook.
Fixed Income (term deposits, government and corporate bonds)
Despite the recent rise in bond yields, they are only back to where they were immediately prior to the COVID-19 sell-off in March last year. This still leaves plenty of room for bond prices to fall if interest rates were to keep rising or if another “flight-to-cash” was to occur like in March last year.
Furthermore, credit spreads[ii] are, in many cases, below levels that prevailed prior to COVID despite all the economic uncertainty that still exists.
Finally, banks are flush with cash from depositors and have access to cheap financing provided by the Reserve Bank as part of its monetary stimulus measures, meaning they do not need to offer attractive deposit rates.
Investors in gold generally see it as a store of value to protect against inflation and as a “safe haven” asset. As it does not pay a dividend, rises in “real” yields[iii] reduce gold’s value relative to income-producing asset classes - which is what has happened recently.
Power of relative value investing
Ardea Investment Management (Fidante issues the ActiveX Ardea Real Outcome Bond Fund) believes it is hard to predict whether inflation is headed higher or not.
But what if there was a different way to earn an income from bond markets that didn’t depend on making this prediction correctly?
A lesser-known but nonetheless long-standing approach to fixed income is pure “‘relative value” (RV) investing.
Pure RV investing does not rely on conventional fixed income return sources and is therefore largely unaffected by whether bond yields and inflation are high, low, rising or falling. Nor is it reliant on credit risk or trying to predict the direction of interest rates.
Instead, a pure RV approach focuses on pricing inconsistencies in between closely related instruments with similar risk characteristics in a highly liquid government bond, cash and related interest rate derivative markets.
In a theoretically efficient market, these instruments should always be consistently priced with one another.
However, in reality, Ardea continually observes pricing inconsistencies due to the buying and selling activity of diverse market participants with different objectives such as investors, central and commercial banks, insurance companies and governments. This results in temporary demand/supply imbalances, creating RV mispricing opportunities.
These pricing inconsistencies can be isolated using a wide range of risk-management tools, such as interest rate derivatives, which strip out unwanted market risk in order to profit irrespective of the level of yields or movement of overall interest rates.
Unlike conventional fixed income investments, which may be stuck with low returns when yields are low, and may also incur capital losses if rates rise, a pure RV investing approach can generate returns that are independent of the level of yields or direction of interest rates.
Furthermore, by embedding strategies that explicitly benefit from interest rate volatility – like what we are seeing now – investors can profit directly from the disagreements taking place in the market right now, without needing to pick a side.
The bond vigilantes may yet win the day, or the central banks may force them back. But we think fixed-income investors need a third choice that enables them to sit out this fight. Relative Value fixed income may be that choice.