Inflation, interest rates and our investing style
Economists and market participants are focused on the US 10 Year Treasury Rate, which increased from 0.93% at the start of January to 1.74% in mid-March. In fact, the rise in bond yields commenced in August 2020 during the midst of the pandemic, increasing from an all-time low of 0.54% as COVID-19 vaccines were approved. The pandemic induced economic pessimism converted to vaccine-driven economic optimism.
Rising interest rates are typically headwinds for stocks as they are valued by discounting all future cashflows to a valuation today. The discount rate used to discount all future cashflows is linked to the risk-free rate or the US 10 Year Treasury rate, and so as interest rates increase, the discount rate used by analysts to value stocks increases as well. This in turn leads to a lower stock valuation, all else equal.
Not all companies however are affected equally by rising interest rates. Companies that are investing heavily today for growth in the future are more negatively affected than companies that are harvesting cashflows today.
Our approach identifies the truly high-quality companies that are innovating and possess long-term sustainable competitive advantages. These types of companies do tend to under-perform when we see sharp rises in interest rates, as we have seen in the first few months of 2021. We in fact saw similar conditions in 2013, 2016 and 2018 where high-quality, innovative companies were indiscriminately sold off, only to see them march higher in the years ahead. Yes, it was a period of short-term under-performance, but we think 2021 is another rare period, where investors are given the opportunity to invest in high-quality growth companies at an attractive price.
We think there are secular reasons to believe that inflation and therefore 10 Year Treasury rates will remain lower for longer, creating an environment that is supportive for investors like us. These secular reasons include technological advances, ageing population, high debt levels and consumers’ preference to save. Despite the eye-catching headlines, the financial market pundits are simply looking in the rearview mirror when they exclaim that the inflation rate is the highest level since 2008! Although this is true, the high inflation rate we are seeing today is unsurprising given the depressed levels of last year, and also misses the point that investments are made based on the future and not the past. When we look at the data, it suggests to us that broad-based growth and inflation will still be hard to come by, and we therefore need to invest in companies that are innovating and are in positions of strength. So what data are we looking at?
The consumer price index in the US rose at an annual rate of 5% in May, an increase from 4.2% in April and the highest since 2008. However, used cars, airline tickets, hotel accommodation, entertainment and other COVID-19 related items drove most of the inflation. In fact, 20% of items (which were related to the re-opening of the economy) drove most of the inflationary pressures, and 80% of the items saw modest price increases. We anticipate the high inflation rates in these few items to be temporary and expect it to moderate as the economy adjusts to business-as-usual post COVID-19.
US household debt to income levels fell to 85% compared to 96% last year. Despite significant fiscal savings, households are reluctant to spend, hindering economic growth. Perhaps scarred by the 2008 Global Financial Crisis, there seems to be a behavioural change where consumers demonstrate an increased preference to save, crimping spending and economic growth.
Multiple years’ worth of durable goods consumption occurred over the last 15 months at the expense of spending on services, as we were all stuck at home. The market for big consumer items is US$2.4 trillion, which is a multiple of the combined spending on sectors that are expected to benefit as the economy re-opens (restaurants, airfares, hotels, cruise lines). We expect consumer spending on goods to revert back to historical levels, causing a significant drag on US economic growth in the next 6¬12 months.
80% of the US fiscal stimulus has already been spent, and so the ‘free kick’ to economic growth will taper considerably in the second half of the year.
Commodity prices have started to roll off, and bond yields have moderated.
We think the structural challenges faced by the global economy will re-emerge as we recover from the pandemic, and the way to invest in this low-growth world is to identify truly high-quality companies that are innovating and possess long-term sustainable competitive advantages.
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Past performance is for illustrative purposes only and is not indicative of future performance.