There is no doubt that global economic data is improving, led by the Eurozone, and that central banks will continue to slowly reduce the dose of monetary policy morphine by winding back quantitative easing policies and increasing cash rates. This has very large ramifications for stock and sector selection going forward, as I continue to write in these notes.
I believe global bond yields and cash rates have bottomed for our lifetime. They are both artificially low and it’s fair to say all global central banks are now behind the curve and need to play catch up. Inflationary pressures have bottomed and wage pressure is picking up due to tightening employment markets. Industrial commodity prices have also bottomed and all around deflationary pressures are becoming reflationary pressures.
With central banks being the largest buyer of bonds for the last few years, even small changes like not reinvesting maturing securities will have an effect on bond yields. This is what the FED and ECB will do in the latter half of 2017 as they shrink their massive balance sheets
And make no mistake, the German 10yr Bund and US 10yr Treasury Bond are the key to everything. If you get the direction of German Bunds and US Treasuries right over the next 12 months, you will most likely get stock and sector selection right globally and locally.
I believe German Bunds will rise from the current .56% to 1.00% over the next 12 months, while US 10 Treasuries will rise from the current 2.33% to 3.00%.
It’s worth looking at longer-term charts just to remind ourselves how low these bond yields are and how easily they could rise.
German 10yr Bund yields
US 10yr Treasury yields
We need to put in context that bond yields and cash rates have been falling since the GFC, to the point where most people believe this is a “new normal” of very low cash rates. If an event goes on for long enough people start considering it “structural change”, but in my view, this period of ultra-loose monetary policy was exceptionally long, but cyclical like all monetary policy cycles.
The no.1 rule of investing is “Don’t fight the Fed”. In fact, don’t fight central banks when they are acting in a coordinated way, as has been the case for almost the last decade.
That rule works both ways, and my opinion is you don’t fight central banks when they are tightening policy and reducing their balance sheets. This is particularly so when all asset classes are expensive, after a decade of cheap money, and in equities anything that has bond like characteristics is being priced inverse to its yield, like a bond.
So what happens when bond yields and cash rates rise due to growth and inflation surprising on the upside?
- Capital losses in bonds
- Cyclical & Value equities outperform Defensives & Growth equities
- Volatility picks up
- Active beats Passive
- Violent Rotations
This week you’ve seen a clear example of all of the above commencing. Better-than-expected economic data in the Eurozone and USA triggered a sell off in bonds. This led to cyclicals and value strongly outperforming defensives and value.
At the same time, we also saw earnings surprises from the world’s biggest cyclicals, such as Caterpillar (CAT), and earnings disappointments from some of the world’s biggest growth stocks, such as Alphabet (GOOGL).
Globally, banks and resources appear to have the greatest upside leverage to rising bond yields. This makes perfect sense and will continue as bond yields rise. On the flipside, healthcare, infrastructure, supermarkets, telecommunications, and Real Estate Investment Trusts appear to have the biggest downside leverage to rising bond yields.
In an Australian context, this most likely means that banks (now APRA is out of the way) and resources will outperform the rest of the more defensive sectors. This is despite the fact the RBA will not be raising cash rates any time soon.
Rising bond yields are a global event with local ramifications. It is unwise to think purely domestically in these major global inflection point events.
Obviously, it’s unwise in a portfolio to get positioned completely one way. While my fund is positioned for reflation in particular through large investments in global banks, in Australia I think there are stock specific global earning opportunities to be taken advantage of right now.
While I was alone predicting the Australian dollar to 80 US cents earlier this year, that has occurred and I now think the vast bulk of the short-squeeze in our dollar is behind us.
From this point on, I think there is downside risk in the Aussie dollar, particularly vs the US dollar, as interest rate differentials diverge in the second half of this year and into the first half of 2018.
AUD/USD: overbought
What we need to take into account is most of the Australian dollar strength has really been US dollar weakness. The broad US Dollar Index (DXY) has fallen -8.85% this year alone and has now reached a major support zone, which I think it will hold and recover from.
US Dollar Index (DXY) 2017 YTD
If I am right and the US dollar bottoms/Australian dollar peaks short term, then the pullback in ASX listed US dollar earners has been too severe over the last month.
My fund has been adding to Aristocrat (ALL) and Treasury Wine Estates (TWE) into weakness, feeling the earnings outlook is unchanged and the only thing driving short-term negative sentiment is an Australian dollar that won’t persist at current prices.
The other large cap ASX listed US dollar earner most likely worth a look at current prices is Macquarie Group (MQG), whose shares have significantly lagged the global financials rally due to Australian dollar sentiment.
We also think the Australian dollar is peaking versus the British Pound (GBP) and we have increased our exposure to stocks such as CYBG PLC (CYB), EML (EML) and Link Group (LNK), all of whom have large British Pound revenue streams.
While we are happy to increase our exposure to the right stocks here and around the world because the world is advancing economically and earnings will follow, we are also cognisant that volatility can only go one way from here: UP
Equity volatility has been squashed by central bank volatility and the explosion in ETF demand. The VIX is a remarkably low 9.43, which means buying index option protection is cheap.
VIX index: remarkably low
I think we all need to condition ourselves for volatility to pick up from here. You could argue that has already started in the ASX200, which doesn’t seem to know what it’s doing on more than a 24-hour basis. The only recent trend on the ASX has been choppiness.
ASX200 last 30 days…UP/DOWN/UP/DOWN/UP….no trend other than daily volatility
I continue to believe this is a major moment in markets. I believe the “great rotation” has commenced. It isn’t obvious to all, yet, but as bond yields and cash rates rise, it will become obvious where value is, and isn’t.
Make sure you own enough global cyclicals and financials, yet be cautious on the most popular stocks of the last three years, particularly large cap US tech.
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 regards to your circumstances.
