Why the yield curve might predict returns for 2021

By Iain Power

The thing to remember about interest rates and the long-term risk-free rate in the US is that this is the rate used to discount the future cash flows in valuations of every single security.

We are in an environment where economies are dealing with Covid and the pathway to normalisation is looking a lot clearer for some of the bigger geographies. This has big implications for the risk-free rate or the long-term US bond which is the cornerstone for rates around the world in terms of what is used to discount cash flows.

If we take a step back and see what has happened to rates through Covid, we see that prior to the pandemic we had the US 10-year treasury trading at about 3.2 %. Once Covid had hit, we saw an enormous injection of monetary stimulus and rate cuts around the world. On the back of these fears the US 10-year bond dropped all the way down to 50/60 basis points. As things have started to normalise this rate has slowly started to pick up, and we have recognised some important things.

As rates come down, that gives a boost to many risk assets and markets around the world whereby P/E multiples and valuations have expanded because the discount rate has fallen. In particular, those securities and shares which have higher growth rates have got a disproportionately bigger benefit to a falling discount rate.

But now we are now in the reversal of this process. As economic growth starts to normalise over the next 12-to-18 months, what’s important to recognise is that real interest rates in the US are still negative, at about minus 60 basis points, and we expect them to at least get to zero or possibly turn positive by this time next year.

What does that mean? It means we would not be surprised to see the US 10-year treasury get back to the 2.5% mark this time next year which has quite big implications for investment portfolios and some of the securities or the type of securities held in portfolios. Those growth or high P/E shares will be more negatively affected by a higher discount rate because a bigger proportion of the value of those shares sits in the long-term value, as opposed to the economically sensitive stocks where a lot of the value sits in the front-end of the discounted cash flows.

This is also the reason that there has been talk of rotation out of expensive tech shares into some of the more value-orientated, economically-sensitive shares, which will be less negatively affected by what we will start to see in terms of rates and will also benefit from the stronger economic recovery that we expect.

The sense of what those rates are going to do will have a big effect in terms of the different securities investors are holding, and our sense is that many investors are still crowded in some of those long-duration, high-growth assets and we are likely to see those wash out as the interest rate slowly starts to tick up as it has been doing.

What is the potential effect of the shift on global asset class returns?
It creates an environment where the margin of safety required has to be bigger. Assets which are expensively priced are likely to see more headwinds. More importantly, it’s not just equities. If you look at our own bond markets, the move in US 10-year rates has directly translated into pushing up local yields, and likewise across many other markets around the world. Particularly Emerging Markets, which will come under pressure when that US rate rises back to the level that it starts to look attractive from a global yield point of view. At that point it starts to suck capital out of emerging market assets and back in to the US dollar and into the US treasury.

All of these factors together with the fact that the US is probably leading the developing world in terms of their Covid vaccination programme (having vaccinated more than 40% of their population), the US is likely to emerge first when compared to Europe and the other developed markets. This will create further pressure behind that interest rate because the economy will recover very powerfully. Forecasts this year are for 6.5% GDP growth in the US which is an enormous number that would push that economy well in excess of pre-Covid GDP levels, which made it hard to argue why real rates should still be negative 60 basis points when the economy is likely to be in a fantastic position.
The effects of high interest rates will be felt across all asset classes. It is going to increase the need for margin of safety. It will put pressure on expensive assets and likely on emerging market interest rates as we have recently seen. Emerging Markets central banks have started to push up rates indicating a change in monetary policy to become more restrictive, which makes the waters we are going to be sailing a little choppier.

What will the effect be on the rand?
Central banks are erring on the side of wanting more growth and employment and less focus on inflation. This gives further credence that rates are likely to surprise on the upside. If central banks are not going to respond like they have in previous cycles because they want inflation to run a little bit hotter, then we need to think about those Emerging Market currencies where the fundamentals are not as strong as others. South Africa, Turkey, and some of the LATAM countries for example, due to their fiscal problems are vulnerable should the US 10-year treasury reach 2.5% – 2.7% in the next 12 months.
Central banks have really changed their tune from being on the back foot to being on the front foot, waiting to get a better sense of inflation and the strength of the economy first. This gives us a sense of where the risks lie in terms of those rates and what is prudent from a portfolio perspective, such as some of the lower risk, higher yielding assets where one is likely to weather that storm a bit better.