Olly Russ

What do higher rates mean for European equities?

Olly Russ

The bull super-cycle in global bond markets has lasted nearly four decades, beginning in the early 1980s with US 10-year yields peaking at very nearly 16%, before they were driven down to historic lows of just below 1.5% by June 2016. Albeit with periods of intermittent volatility, most investors below retirement age have had this comforting rates backdrop throughout their careers. The move has been so unidirectional for so long, investors have perhaps forgotten what happens in periods of rising rates.

 

After such a prolonged period of falling yields, it takes some effort to readjust expectations to rising rates. Nonetheless, the effort is worth it, because the direction of US yields in particular could potentially impact every investment decision, from which asset class, to which region, styles, sectors and even stocks investors should select.

 

Why equities as rates rise?

Given the recent positive correlation between bond and equity markets, should equities not sell off alongside bonds as rates rise? Not necessarily.

 

Increased inflation expectations have led to a realisation among investors that there might be four hikes from the US Federal Reserve in 2018. Although this led to a synchronised sell-off in bonds and equities, as well as a spike in volatility, this correlation need not persist in the medium term.

 

Deflation is bad for equities, as is high inflation – when markets tend to become less optimistic, and therefore reduce the amount they are willing to pay for future earnings. But for moderate inflation, equities are usually regarded as the ultimate inflation hedge. In fact, using US data since 1872, JP Morgan suggests that equities achieve their highest price/earnings ratio when inflation is in a range of 1% to 3%.

 

It is relatively easy to see why moderate inflation could assist equities. Companies can demonstrate revenue growth, as customers become used to paying more for the same. There might be scope to raise prices a little ahead of actual cost increases, expanding margins. Too high a level of inflation however, and companies will fail to adjust prices quickly enough, causing margin squeeze.

 

Which sectors should benefit?

If we accept that rates might be moving higher – but not too far – which equity sectors stand to benefit? There is a strong correlation between rising rates and ‘value’ outperformance over ‘growth’ (see chart). If we decompose the value trade, we see a very strong positive relationship between the banks sector (and financials in general) and yields.

Olly Russ: And which sectors should be avoided?

Source: Bloomberg, 28.02.2018

Why is this? For banks, their essential business is acting as a middle man between borrowers and depositors. This means taking a cut of the differential in interest rates offered between those two classes. In very simple terms, at higher levels of rates, there is a larger pie to take a slice of. Banks themselves also have large cash deposits and bond holdings which attract interest as rates go up.

 

Depositors’ interest rate sensitivities also drop as rates creep higher. Customers may not be inclined to move accounts when the interest rate on offer differs from bank to bank by say 10% versus 9%. However, at 1% versus 0%, they are more likely to move. Banks are also very swift to reprice loans when interest rates rise – they often seem to lack the same alacrity with deposit rates, unless rates are going down, in which case the reverse is true.

 

Rates rising for the right reasons – that is, an increasing economic expansion – also would tend to mean that banks’ bad debts would start to fall rapidly as companies and individuals find it easier to stay cash flow positive.

 

For insurers, the case is slightly different. In effect, an insurer gets to invest policyholders’ money in the interim between charging them for a policy and paying out on claims. This typically means large bond holdings. Insurers have done well as bond yields have fallen, but rates fell to such low levels that the income they could generate on new policyholders’ money fell almost to nothing. This ‘reinvestment yield’ is closely watched by investors, as without it the business model of general insurers starts to break down.

 

Similarly for life assurers, some products have explicit guaranteed levels of income which can be impossibly expensive to cover at low market yields, but become far more manageable as rates rise.

 

Outside of financials, the strength in value often goes hand-in-hand with outperformance from cyclical stocks, those whose profitability tends to be positively correlated with economic trends. Here the connection is less to do with interest rates (often they are actually geared businesses which will see their interest bill expand) and more to do with the improving economic outlook which has prompted expectations of higher rates.

 

And which should be avoided?

Olly Russ: Which sectors should benefit?

Source: Bloomberg, total return in local currency,31.12.2017 to 28.02.2018

 

At the other end of the spectrum, are the so-called ‘bond proxies’ – consumer staples, tobacco, health care, utilities, telecoms and the like. Some of the big household product names – i.e. Nestle and Unilever and so on – would appear to have peaked last year. We hold relatively little in this sector, as we believed it had already become very expensive. The power of rising rates is becoming increasingly apparent in year to date returns: real estate, utilities, health care and consumer staples are the four worst performing sectors in Europe this year, and financials the best.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in Funds managed by the European Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. Investment in the Liontrust European Enhanced Income Fund writes out of the money call options to generate additional income. These call options will be “covered”. Unitholders should note that potential capital growth of the Fund would be capped if these call options are exercised against the Fund and the Fund’s capital returns could therefore be lower than the market in periods of rapidly rising share prices.

Disclaimer

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Monday, March 12, 2018, 10:46 AM