Will rising yields sink all assets?

The winding down of the quantitative easing (QE) monetary policy in the USA will lead to significant changes in the relative performance between asset classes and within asset classes. For investors, the most immediate challenge will be to deal with the distortions that QE has created, writes Matt Sherwood.

The statement that ‘a rising tide lifts all boats’ is associated with the notion that improvements in the economy increases workers’ incomes, and government policy therefore should focus on improving the general economic environment. 

The saying is incorrectly attributed to President John F. Kennedy who used the term frequently while in the White House, but the saying’s origins date back 15 years earlier (when Kennedy was an still aspiring Senator) to the New England Chamber of Commerce who used the saying on their marketing material. 

While the phrase is also a favourite of former US Treasury Secretary Robert Rubin, it is obvious that not every firm and worker benefits from a strong economy, due to the ‘creative destruction process’ of capitalism, where inefficient firms and industries make way for better operators. 

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Nonetheless, while the saying has been used for over five decades, Warren Buffett added to it during the global financial crisis in 2008/09 by saying “A rising tide lifts all boats. It’s not until the tide goes out that you realise who’s swimming naked and what we are seeing at some of our large institutions is a truly ugly sight”. 

The weakest recovery in US history 

The global economy has since improved, but the US recovery remains the weakest in history with total growth of just 8.2 per cent since the trough of June 2009. 

This is relative to an average recovery of 21.7 per cent at the corresponding stage of the last 20 business cycles dating back to 1874 (see Chart 1). 

Although the US economic recovery has been subdued, the US sharemarket has continued to rise due initially to large cost-out drives by US corporations, which have produced increasingly marginal gains for US corporate earnings.

QEIII to end by mid-2014, if all goes right 

More recently the US sharemarket has been supported by the US Federal Reserve’s unorthodox stimulus.

However, in June Chairman Bernanke gave markets more guidance on how the US Fed plans to progressively withdraw this support.  

Markets had a sharp reaction to the news as tapering was eventually expected, but the program’s cessation was new information. 

Good news for developed market industrials 

The most important question for investors is whether the US economy can recover fast enough to push US unemployment rate below the US Fed’s desired level of 7 per cent. 

Markets at present are very fragile and the reaction to the Fed announcement of potential tapering in 2013 highlights what little tolerance there is for a shift in policy.  

Higher rates will curb the US housing recovery 

One concern is what impact rising bond yields may have on the US housing recovery, especially as the rebound has been driven by foreigners and private equity firms. 

The difference between mortgage applications (from US citizens) and overall new home sales (from all participants) indicates that there has been no recovery in US credit demand at all (see Chart 2).  

QEIII’s ending – a negative for emerging markets 

One of the primary beneficiaries of the US Fed’s QE program has been the emerging markets. When the US currency was declining, global investors clearly favoured investments in the emerging markets (see Chart 3) and commodities over USD-based assets. 

Chinese growth in 6 per cent zone 

China was a bastion of stability throughout the global financial crisis in 2008/09 thanks in part to the explosion of credit that was unleashed, initially through the formal banking system and then through a raft of ‘shadow banks’ and off-balance-sheet vehicles. 

However, more recently this credit explosion has caused some indigestion in the Chinese financial system, with short-term rates surging as banks struggled to obtain funding in short-term money markets.

This all appears to be part of a new plan by the Chinese authorities to constrain liquidity and reduce credit growth.  

Rising yields and shares 

Australian investors have a greater challenge than many of our advanced market peers in that bond yields have recently backed up (due to QE unwinding) whereas the domestic economy continues to moderate, increasing the probability of further interest rate support by the Reserve Bank of Australia (RBA). 

History demonstrates conclusively the inverse relationship between bond yields and the relative performance of cyclical stocks (see Chart 4), and since the GFC in 2008/09 this relationship has intensified (correlation post-2008 has risen from -57 per cent to -88 per cent). 

The recent rise in bond yields has seen cyclical stocks (including industrials, consumer discretionary, IT, materials and energy) outperform, reversing the trend for the past two years. 

As tapering continues to be factored into markets, higher-yielding stocks will likely remain in demand, but are likely to experience little price growth due to stretched valuations and modest earnings potential, whereas cyclicals should be supported by further rate cuts by the RBA. 

Implication for investors 

The ending of US QE program will see some changes in the relative performance between asset classes and within asset classes. The most immediate challenge for investors is to navigate the unwinding of the distortions that QE created, but during this process shares and credit are likely to continue outperforming government bonds. 

The region most exposed to the QE withdrawal is the emerging markets, as the process is likely to culminate in lower asset prices, rising interest costs and (probably) lower tolerance for risk. 

Fortunately, in Australia the deprecation of the Australian currency is doing a lot of the RBA’s work. This is allowing cyclical sectors that were constrained during the mining investment boom to experience a bit more support. 

However, the currency is unlikely to be at a level that the RBA sees as appropriate, as it still remains 24 per cent above its post-1983 average.

In this universe, weak business models are likely to be exposed, whereas companies generating strong surplus cashflow are better placed to deliver on elevated earnings guidance, and any firm that misses on earnings is likely to be punished more harshly by investors than has been the case since 2009.

Matt Sherwood is head of investment markets research at Perpetual Investments.