After a short period of relative calm, it appears rising global bond yields, led by US Treasuries, are again going to prove a headwind to equity markets.

The rise in bond yields, and associated rise in volatility, was what triggered the early February correction in equity markets. We need to be aware that US bond yields have made new highs and have taken out technical resistance. The new highs in bond yields were too much for Wall Street, with the S&P500 intraday reversing and ending around 1.6% below its highs of the day.

Pay day

I have been warning investors on bonds, and bond like equities, for a long-time. I believe we are going from Central Bank quantitative easing (QE) to Central Bank quantitative tightening (QT). At the same time, the US has lost all fiscal discipline under Trump and will now run huge budget deficits that require record issuance of US Treasuries. The world, led by so called bond vigilantes, is going to charge the US a higher interest rate to fund its deficits.

After a decade of QE, Central Bank action will turn negative in 2018

• Fed balance sheet redemptions will increase and ECB purchases will cease
• At the same time, increased fiscal deficits will see “issuance” increase
• The combined impact is a ~$500 billion step up in supply of US Treasuries

While some bond fund managers get annoyed about equity fund managers writing on bonds, the simple fact is the direction of the “risk free rate”, and the rate of change of the risk-free rate, is crucial to overall equity market pricing and stock and sector selection. The very first thing I look at when I get up is the “risk-free rate”, also known as a US 10yr Bond. This is particularly so right now.

Similarly, the size of cumulative central bank balance sheets has been highly correlated to asset prices.

If I am right and central bank balance sheets have peaked and the risk-free rate is rising, then we are almost certainly past the end of the ultra-low volatility period in risk assets.

Hang on

You must now condition yourself for a rise in volatility. That is clear to my way of thinking. You are going to see equity index moves driven by bond market pricing. You are also going to see rotation from perceived defensive equities, or equities with bond-like characteristics and durations.

I say again, just because a company operates in a defensive sector doesn’t mean its share price will prove defensive. I am of the view that some of the largest potential capital losses over the next few years lie in perceived defensive sectors. As bond yields rise, the price paid for defensive equities will fall, led by the infrastructure, healthcare, utility, telco and REIT space.

Yes, many of the current dividend yields in these sectors are attractive. But that won’t stop a P/E de-rating as bond yields rise. That P/E de-rating will equate to capital losses.

Darlings to dive

In Australia, the three large-cap defensive stocks I am most cautious on are Transurban (TCL), Sydney Airport (SYD) and Ramsay Healthcare (RHC). I realise these three market darling stocks have plenty of cheerleaders who think every dip is a buying opportunity, but this time they will be proven wrong. This time rising bond yields will over-ride any stock specific story and I think all three are at risk of 15% to 20% capital losses while still paying their dividends.

A classic example is Sydney Airport (SYD), which reported earnings yesterday that didn’t meet analyst expectations. SYD has a great narrative about rising international tourism numbers, but in my view, is overvalued and likely to be de-rated in the months ahead.

Coming into the result yesterday there were 9 buys, 3 holds and 0 sells on SYD. The median 12-month price target was $7.33. However, SYD has clearly broken down through the 200-day moving average and I would argue that the 5-year uptrend is over.

SYD 5-year uptrend broken

As also happens regularly in corporate Australia, a long-serving very well-regarded CEO recently stood down at SYD, just as things start to get a little tougher.

I would argue that SYD has squeezed every revenue dollar out of the Sydney Airport asset and incremental revenue growth from here will require larger capital expenditure.

Interestingly, for the third year in a row the SYD capex budget appears to have increased. According to Macquarie Research, last year SYD extended the 5-year spend and this year it has kept the spend rate constant but now over four years (2018-21). Restating, SYD will spend $1.8 billion over FY16-FY20, $0.5 billion more than the agreed envelope, and committed to another $0.4 billion in FY21. SYD remuneration is additional international volume above base forecasts. This will recover funding costs, but not provide a full equity return. The later will need to be negotiated with airlines for FY21. There is always a risk that not all of the spend will be recovered.

The second issue is the capex spend rate is not falling. Much of the spending is for the growth in peak periods, ie, 40% of traffic. As traffic growth stays strong, the airport gets increasingly complex and constrained, and Macquarie sees the likelihood capex spend is shifting to $0.3 billion to $0.35 billion up from a $0.25 billion historical average.

Don’t get me wrong, SYD is a true monopoly business and Australia’s gateway airport, but the asset has been squeezed very hard and capex is increasing to increase revenue. It will have a competitor of sorts in 2026 in the Western Sydney Airport, but right now that doesn’t concern me.

However, on a 2018 P/E of 36 times, offering 7.8% EPS growth and a 5.8% distribution yield (100% payout), it’s just too expensive for me.

SYD is a classic example of a defensive asset that isn’t proving defensive in share price terms. Yes, the dividend yield of 5.8% will be paid in 2018, but the stock just lost that in capital falls in two days since reporting. This is the risk in ALL BOND LIKE EQUITIES: your capital loss could be multiples of your annual dividend yield as the interest rate cycle turns up.

I think SYD will head below $6.00 while those of you who took up the recent Transurban rights issue at $11.40 should consider selling them while they’re still fractionally in the money.

Yes, my cautious views on Sydney Airport, Transurban and Ramsay Health Care are not consensus, but they will be once investors and analysts realise the 30-year bull market in bonds is over. Defensive sector doesn’t mean defensive share price at the turning point of interest rates.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.