In this week’s market update: investors start to worry about inflation; the dark side of ESG; and the latest bubble watch.
Investors will always find something to worry about. And right now, the concern on everyone’s mind is inflation. Is it coming back? What impact will it have on first the bond market and then shares? Can the Fed keep up its easy-money policy in the face of rising prices?
Just as political uncertainty always shows up first in the currency market, inflation fears are first seen in the bond market. Inflation is the bond investor’s biggest worry because it reduces the value of fixed-income investments, both the value of the fixed interest rate, or coupon, that they pay and also the value of the capital that’s returned to investors when a bond matures.
Inflation was the reason that bonds were such a poor investment in the 1970s. And the absence of it since the 1980s, and the fall in interest rates lower inflation allowed, is the reason why bonds have been such a great investment for such a long period in recent years - in fact decades.
When investors fear a return of inflation, they push bond yields higher to compensate. If you think that your money will be worth less in the future than it is today, then you require a higher income in the meantime to make up for that expected loss. Higher bond yields equate to lower bond prices. It’s simple arithmetic.
Well since the election of Joe Biden in November, and the emergence of a new more inflationary narrative based around continuing high levels of US government spending and recovery from the pandemic, bond yields have moved progressively higher. At the start of the year, the 10-year Treasury yield was 0.9%. It is now around 1.3%. February looks like delivering one of the biggest one-month increase in yields for several years.
Inflation expectations, which together with interest rates are the main driver of bond yields, are also on the up. The 10-year break even rate, a guide to expectations of inflation in the future is now at its highest since 2014 at 2.2%. That is above the Fed’s 2% target which in more normal times might suggest that the Fed would be thinking about tightening interest rate policy a bit.
These are not normal times, however. The Fed is determined to keep interest rates and so bond yields low to stimulate the economy but also to generate a moderate amount of inflation. Why would it do that?
A little bit of inflation is a good thing. It encourages people to spend now rather than put off purchases to the future. That boosts the economy. But it is also a good thing when governments have been obliged, usually because of an expensive war, but this time because of the cost of fighting the pandemic, to issue bucket loads of debt.
When that happens a government has three options: they can pay the debt off over time by raising taxes; they can refuse to pay back the money (not really possible for a developed economy like the US or Britain); or they can reduce the real debt burden by allowing inflation to increase the size of the economy while leaving the amount owing unchanged.
This is what happened after the second world war when governments realised that the only viable option among the three was to let inflation run hot while simultaneously keeping the cost of servicing debt manageable by putting a cap on interest rates.
The problem in a free market is that investors will constantly test and challenge the authorities resolve in doing that. Sometimes this is referred to as the action of ‘bond vigilantes’. And we are starting to see those vigilantes saddling up and challenging the Fed again.
So, what does this mean for our investments? First, in the bond market it puts the prices of all types of bonds under pressure. If government bond yields rise, the price of government bonds falls. But there is a knock-on impact on other types of bonds too because these are priced by comparison with the perceived safety of government bond yields.
A company bond will always yield a bit more than a government bond to reflect the greater chance that a company will go bust and default on its obligations to investors. So, if government bond yields rise then the only way that a company bond can avoid doing so too is if the gap between the yields, known as the spread, narrows. There is a limit to how far this process can go, so in due course rising bond yields will flow through the whole spectrum of bonds.
And what does that do to shares? Well, one of the reasons people invest in shares today is because they offer a higher yield than bonds. If the gap between the two narrows, then shares become that little bit less attractive to investors.
Another reason is that the present-day value of a company’s future earnings is calculated with reference to bond yields. If interest rates are low then you are less concerned about waiting for the value in a share to emerge - there is less of an opportunity cost. A company which is expected to produce rising profits long into the future is, therefore, worth more to you in a low rate environment than it would be if interest rates were higher.
It’s a tricky concept but it is one of the key reasons why long-term growth companies, like the tech giants in America, have been valued so highly in an era of rock bottom interest rates. At the margin, rising interest rates and bond yields can be expected to hit the value of these growth shares. And relatively speaking they have. So-called value stocks, where more of that value is in the here and now rather than in the form of hopes for the future, have outperformed the tech stocks more recently.
When this growth to value rotation gets underway, one beneficiary tends to be smaller companies, which are more exposed to economic growth than their bigger counterparts. Since the start of November, the Russell 2000 index of smaller US stocks is up 47% and by 15% year to date. That compares with less than 20% and 4% respectively for the S&P 500 index.
Also on a tear thanks to the rotation from future growth to growth right now is commodities. Copper, the bellwether commodity, this week rose above $9,000 a tonne for the first time since 2011 on the back of speculative bets on higher prices on the Shanghai Futures Exchange. Copper has now doubled since its low last spring, and is up 15% so far this year.
An investment that does well when interest rates are low but struggles as they rise is gold. Gold pays no income at all so if the yield on bonds rises then so does the implied opportunity cost of holding gold. This week gold has fallen back to around $1,760. That’s its lowest level for nearly a year. Last summer, in the thick of the pandemic, gold rose to a high of $2,075.
The relative performance of big and small, growth and value, shares and gold, commodities and financial assets is a reflection of investors’ perpetual search for the next big thing. This is normal investor behaviour but so too is the tendency for investors to overdo their enthusiasm for one type of investment, however good the story.
The latest example of this may well be the wave of cash flowing into anything that investors perceive as ‘green’ or ESG-friendly or sustainable, however you want to express it. The S&P Global Clean Energy index, for example, has nearly doubled in the past year and now trades on 41 times the expected earnings of its constituent companies. By comparison, the S&P 500 trades on around half this multiple of earnings.
The rise in valuations is being driven by what Larry Fink at BlackRock has called ‘tectonic shift’ towards sustainable investments. Funds linked to environmental, social and governance factors took in nearly $350bn last year, around twice the inflows in 2019.
And valuations are not the only concern with ESG, where questions have started to be asked about the way in which trying to avoid one set of evils - pollution, climate change etc - might merely replace them with a different set of undesirable outcomes - tax avoidance, job-destroying automation, inequality and the concentration of power in near monopolies.
What it goes to show is that Sustainability is a complex area for investors to navigate. We have to balance our desire to do the right thing, and the temptation to go with the herd, with an objective analysis of both what we are actually investing in and the price at which we are doing it.