April 9, 2021
There has been a decided shift in the bond market in recent months. Investors have begun to focus on the strength of the economic recovery even as central banks press ahead with bond purchases. As a result, longer-term interest rates have more than doubled, returning to pre-pandemic levels. This may signal trouble for high multiple equities, which rely on ultra-low interest rates to justify their hefty premiums. Our portfolios have avoided the risks inherent in both long-term bonds and expensively valued equities, and we believe this will continue to pay off.
Interest rates worldwide cratered to historic lows in 2020 as central banks embarked on an exceptional stimulus program in response to the pandemic. Following the lead of other central banks, the Bank of Canada cut its policy rate to near zero and purchased bonds in the secondary market. The yield on the 30-year Federal government bond dropped below 1% for the first time ever in March and again in June (Chart 1). In the meantime, digital economy stocks saw their share prices soar, both because they benefitted directly from the pandemic via increased demand for their products and services, and as falling rates led to higher premiums for their shares.
Beginning in the summer of last year, however, investors’ mindset began to change. With global economic data showing decided improvement and vaccine trials demonstrating promising results, investors began to discount an end to the pandemic. A mindset change also occurred at the policy level: economists, governments and policy makers shifted away from fiscal conservatism, embracing instead the use of budget deficits to boost growth. Biden’s $1.9 trillion stimulus program, which comes on the back of $900 billion approved by Trump last December – and this on on top of $2.8 trillion injected in March/April 2020 – fits with a new orthodoxy of borrowing at current low interest rates to support economic activity.
With government spending on the rise and so much money being printed by central banks, inflation concerns are now coming to the fore. This new dynamic has pushed interest rates higher. The 30-year Federal bond yield has risen from 0.9% in August 2020 to 2% at end-March, the same level as April 2019 (Chart 1). The impact on bond prices has been significant: the return on the 30-year bond during the last 7 months was –22%.
A secondary impact of the steepening of the yield curve is the effect on high multiple stocks. We have written at length in the past year how falling bond yields have juiced P/E multiples, particularly in the tech sector. Stocks that derive more of their economic value from future earnings, cash flows, and investments are also more affected by a fall in interest rates. Declining interest (or discount) rates – the rate at which future cash flows are discounted in order to arrive at their current value – inflates today’s values. Put simply, in a world where interest rates are close to 0%, a dollar tomorrow is worth very close to a dollar today. A rise in interest rates has the opposite effect.
If interest rates are no longer falling, and indeed begin to reflect expectations for higher inflation and higher debt levels, this might spell even bigger trouble for high multiple stocks than investors realize. The reason is that ultra- low interest rates may not fully explain the elevated premiums investors have been willing to pay. Is “irrational exuberance” therefore partly responsible for the abnormally high valuations present in some NASDAQ stocks? We wonder the following: what will happen if investors realize (1) the era of falling bond yields is coming to an end and (2) numerous reasonably-valued firms tied to the economic cycle will see earnings growth strengthen as stimulus kicks in and the world economy expands this year and next, narrowing or possibly reversing the earnings growth gap relative to growth stocks?
Despite expectations of a faster rise in revenue and earnings than the indexes, our equity portfolios continue to trade at notable discounts to the benchmarks (Table 2).
Our Canadian Equity, International Equity and Emerging Markets portfolios are diversified and structured with well-valued companies that are world leaders in their industry with a compelling growth profile, including:
We have protected our portfolios from excessive valuations present in long-term bonds and high multiple stocks for some time. Governments continue to press ahead with more fiscal stimulus at a time when central banks admit they are willing to let inflation run a little higher than their usual target of 2%. We believe that maintaining a short duration in our bond portfolios is the best strategy in the current environment. Yields could move further upward which could cause great losses for holders of long instruments. In our view, our equity portfolios offer an interesting opportunity for a diversified exposure to well-valued companies with a strong earnings growth profile. Long-term investors should continue to reap the rewards for their patience.
All dollar references in the text are U.S. dollar unless otherwise indicated.
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