Could Value stocks be a hedge against rising rates?
It is widely accepted that interest rates have a big impact on equity markets, said Dermot Murphy, Fund Manager, Value Equities. Specifically, the theory goes that higher bond yields mean a lower discount rate and – all else being equal – that should translate into higher valuations.
The problem, said Dermot, is that relationship is difficult to prove, largely in his view because all else is never equal. Future growth prospects and interest rates are not independent, after all, and when growth forecasts deteriorate interest rates get cut and vice versa. That is why, for many years after the global financial crisis, there was a mantra that “bad news is good news” because it meant interest rates would stay low and help sustain higher valuations.
However, something quite interesting happened last week. US employment data came out on Friday and was much better than expected. The S&P 500 Index opened sharply higher, but as investors digested the impact this might have on inflation and interest rates the market reversed, giving up those gains. We’re now in a situation where good news is now bad news for the equity market, said Dermot. The tipping point appears to be a US 10Y yield of about 1.6%.
Dermot remembers the last time that rising bond yields cause the market to fall. It was late September/early October 2018, when there was a sharp fall in the S&P and a big (albeit brief) rotation from growth into value. That was caused by the US 10Y yield breaching 3%, a psychological barrier that seemed important to the market’s groupthink.
The Fed’s u-turn in early 2019 unwound that dynamic, but it’s notable to Dermot that now the market’s tipping point is materially lower than it was back in late 2018. That is most likely caused by valuations, in his view, and can be clearly seen in the relative performance of the US and UK markets YTD. The S&P 500 is on a cyclically-adjusted PE of 35x, and by that measure it has only ever been more expensive once (during the dotcom bubble), and is up c.2.5% so far this year. The FTSE All-Share Index, by contrast, is on a cyclically-adjusted PE of 16x, which is more in line with historical averages, but is up c.6% year-to-date, weathering the impact of rising yields much better.
Interest rates are having a big impact on the market, but that impact varies greatly depending on valuation. Anything with a low enough valuation may actually be positively correlated to bond yields, and that should be interesting to anyone looking to hedge against rising rates, said Dermot.
The green economy will be silver
The National Renewable Energy Laboratory recently estimated that the number of electric vehicles in the US alone could reach 186 million by 2050, or 66% of all cars on the road, said Joe Lunn, Fund Manager, Gold & Silver.
What does this have to do with gold and silver? Well, every electric vehicle contains around 3 ounces of silver, so given these estimates, around half a billion ounces of silver will be needed to help build this fleet of cars.
Given the structural shortage of available silver and the vital role it will play in the burgeoning green economy, Joe says substantially higher prices seem inevitable. Across the world, silver mines are maturing, input costs are rising (particularly labour which accounts for around 40-50% of operating costs), and the grade of silver able to be mined is declining (the highest grades of silver are nearer the surface). There is still a fair amount of silver left in the ground, but if prices stay where they are, underground mines in Mexico will be high graded, resulting in sub-optimal extraction. In addition, two-thirds of silver currently mined are by-products of other metal mining, like copper, resulting in suboptimal recovery.
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