Equities to have mixed reaction to higher bond yields

Government bond yields have been rising in Australia and globally, which could hurt returns for some equites that are sensitive to interest rates rises, though the big banks are expected to be resilient.

Dr Shane Oliver, chief economist with AMP Capital, expects the Australian 10-year government bond yield to rise to about 2 to 2.25 per cent by the year’s end, but noting that “continuing RBA dovishness and low underlying inflation should help limit the rise in bond yields to this.” Australia’s 10-year bond yield has jumped 88 basis points over the past 12 months to 1.74 per cent.

“The sectors most vulnerable to higher bond yields are technology stocks because of their long duration earnings profile and high-yield sectors like real estate investment trusts, utilities and telecommunications companies,” Oliver says.

MORE ON THIS TOPIC: What rising rates mean for bond funds

Nathan Sheets, chief economist and head of global macroeconomic research, PGIM Fixed Income, says inflation is the key issue for the markets this year. “My expectation is that in the second half of this year, we will see higher inflation than what we’ve seen over the last several years,” says Sheets.

Iron ore prices have recently hit record high levels close to U$200/tonne, other base metal prices are soaring, and oil has jumped since November 2020. Bond yields have been rising in response to expectations of higher inflation, aided by an improved economic outlook with the rollout of COVID-19 vaccines and strong corporate earnings growth in Australia and the US.

“The move in the Aussie 10-year [bond yield] has been faster and larger than in the other major economies, likely as investors have priced the very strong rebound in the economy and the ongoing stronger-than-expected data flow,” says research from UBS.

Australian equity values have become negatively correlated with bond yields (excluding resources). Growth stocks and sectors such as technology and media have sold off the most, while value sectors like insurance and banks have done best, UBS notes.

Growth companies most exposed

Matthew Wilkinson, a senior fund manager analyst at Morningstar, says equity valuations are determined by the discounting of future cash flows by an interest rate.

“So, if that rate is very low, then the valuation outcome is very high—and vice versa. Growth companies have the highest sensitivity to a rise in interest rates as they are relying on future cash flows for their profitability. Also, for ‘super-growth’ companies that are reinvesting in their businesses such that they are not producing any free cash flow—their debt funding now becomes more expensive.

“So, it is a double whammy for [super growth companies]: future earnings are discounted by a high rate, and their business costs have gone up,” Wilkinson says.

If long-end rates continue to climb, for those investors positioned in growth-oriented equity portfolios, “we would encourage a more balanced approach across equity styles.”

Bank stocks better placed to fend off rising yields

In terms of value stocks, the big banks are likely to resist the impact of rising yields, according to Morningstar banking analyst, Nathan Zaia.

“There are a couple of things which will be at play,” Zaia says.“The banks have long-dated [debt] maturities which, if replaced, in the current environment would be much cheaper. This should also help ease the burden of refinancing the term funding facility in 2023 and 2024.

“Second, the rising bond market will help the banks generate better returns on their deposit and equity hedges.

“Non-bank lenders, which have no access to deposits, will feel the pressure on margins much more. Banks have 65 to 75 per cent of funding from term deposits, where costs won’t rise in line with bond yields,” Zaia says.

Bonds and equities could fall in tandem

While inflation in Australia is currently benign, the Australian Bureau of Statistics recently said government schemes and housing grants helped to keep inflation down in the March quarter. Without the offset from these grants, the price of new dwellings would have risen, reflecting increases in materials and labour prices in response to strong demand. The Consumer Price Index (CPI) rose 0.6 per cent over the March 2021 quarter and 1.1 from a year earlier.

In terms of global inflation, Dimitris Melas, global head of core equity research at MSCI, says moderate inflation in the range of 2 to 3 per cent would also be a very benign background for equity markets in general and that expectation is currently priced into equity markets globally.

“However, if we see inflation overshooting, this range, I think both equities and fixed income could potentially suffer,” says Melas.

“I think it's likely that the negative correlation could persist but in higher inflation environments, it could break down. And we may see some of these traditional strategies that have provided diversification such as 60 [equities]/40 [bonds]. They actually perform less well in a high inflation environment.

“In this type of environment, other asset classes such as in the clean bonds and even commodities could provide better hedging opportunities,” adds Melas.

Even cryptocurrencies could “help investors manage inflation and even help preserve wealth over time. But … we're still in the early stages. We need to see a lot more development and transparency into how these digital assets are priced, how they're traded,” he adds.

 See also Morningstar Guide to International Investing