Is it ‘rotate out of bond proxy’ time?

We’ve seen it happen a few times so we should be experts by now. You’ve all heard the saying “Don’t fight the Fed” and that’s exactly what it is. There’s a chorus of well-known commentators that are sounding the alarm. They’re concerned about rising US interest rates and the impact it will have on the rest of the world. Last week Warren Buffet released his highly anticipated annual letter to Berkshire Hathaway shareholders. He issued a stark warning to investors about the risks of holding interest rate sensitive stocks that are raising capital or using debt to pay dividends. He urged investors to measure risk by the ratio of bonds to stocks. Buffett highlighted the fact that risk free bonds are indeed risky. He wrote “It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.” But it isn’t just him that’s becoming scared so too are Fund Managers Charlie Aitken and Hamish Douglass.

Charlie Aitken on Monday released a note to his clients saying “The new highs in bond yields are an important development with clear ramifications for equities, particularly in sectors where there has been a “search for yield” from those who had been squeezed out of low returning fixed interest assets by central banks. That reverses now as bond yields head higher.” Then this morning Magellan’s Hamish Douglass came out with this note “If the Federal Reserve is forced to act more swiftly and forcefully than expected, it is reasonable to assume that US longer-term bond yields could jump meaningfully… which could trigger the biggest slump on world share markets since the global financial crisis. In our view, a 20% to 30% global stock market correction is within the range of outcomes in these circumstances.” But are they running scared too early? Using Kensho which is a hedge fund analytics tool, CNBC looked at how the share market performed during periods of major interest rate rises. The findings showed that the S&P 500 rose by 23% on average during 5 out of 6 instances where there was a major rise in rates over the last 30 years. Investors freaked out early February when higher rates were put on the cards. So we can only expect much of the same. The Fed has such a huge influence on the world there’s no point fighting it. Investors can do well to have their investments aligned with current monetary policy rather than against it.

So what is the current state of the Fed and what’s got everyone so rattled?

This week newly elected US Federal Reserve chair Jerome Powell made his debut public appearance this week and said the US economy has strengthened and corporate tax cuts should help deliver higher wages over time. Whilst he didn’t issue a firm growth estimate, he noted that the economy grew at about 3% in the 2H17. Powell also confirmed further gradual rate increases were on the cards in 2018. The market is now pricing in more aggressive US interest rate increases with bond traders upping bets for three US rate rises this year to a 75% and a possible fourth rate rise at 35%. The 10 year bond yield is sitting at 2.92%. If the Fed acts more swiftly than the market expects, which we think it will, you can bet your money that US longer term bonds will soar well into the 3-4% mark. That alone, will initiate a rotation out of bonds and bond proxy investments into safe assets. In-fact it could trigger a massive sell-off in global markets. The 10% sell-off that occurred early February came on the back of a better than expected US wages number which triggered a rise in longer-term US bond yields. It wasn’t sparked by an interest rate rise. Going by Douglass’ comments, if the Fed were to slip in an extra rate raise, that 10% sell-off could look more like a 20%-30% sell-off. Ouch.

With US interest rates tipped to rise four times this year, it will have a knock on effect on the entire global economy. There are clear ramifications for stocks, especially bond proxies. Those yield hungry bond refugees that moved their money into bond like equities a few years ago are in for the shock of their life. Let’s say the taps are being turned off and rates rise. The market behaves like spoilt child. When it does get what it wants, it has a tantrum. So when this all unwinds it won’t happen gently, it will happen violently. Expect to see the market spit the dummy spit like it did with the taper tantrum in 2013. We’ll most likely see a continued dumping of bonds as well.

How are bond proxies affected?

What happens in the bond world usually spills over into the equity world. For those that don’t know, bond proxies are stocks that offer a high and reliable yield. With the onset of low interest rates over the last five years, investors sought higher yielding assets that had bond like characteristics. Equity investments such as infrastructure companies were the perfect substitute. Infrastructure companies offer a revenue stream similar to bonds such as toll roads, rail facilities, utilities, airports, power lines, gas pipelines and REITS. On the flip side banks, commodities and travel companies usually benefit from rate rises. If you think back to September 2016 a similar thing occurred. At its policy meeting, the US Federal Reserve hinted that rates would rise before the end of the year causing a bond yield spike. In December it was confirmed when they raised for the first time in a year and foresaw another three in 2017. That caused a short but temporary sell off in bond proxy land. Bond proxy stocks such as Transurban (TCL) fell by roughly 20%.

Our message to investors: Now could be a good time to lock in profits. TCL is already down 10% this month. Bond proxies have had quite a good run so a correction or rotation out of bonds will bring valuations back to normal levels. Once the bond sell-off is over, buy back in. Let the bond refugees clear out once the stock has bottomed there will be a time to buy back in. Bond proxies make close to 40% of the ASX200 by market capitalisation.

So what should investors do?

  • Keep an eye on bond proxies.
  • Buy floating rate bonds.
  • Buy stocks which benefit from a strong US dollar.

The most risky assets in the Aussie equity market are infrastructure and high yielding defensive stocks. As the Quantitative Easing drug wears off and central banks undertake Quantitative Tightening… expect infrastructure to deflate, property stocks to reverse, longer dated bonds to sell off and an unwinding in risk assets. On the flip side, bank stocks benefit when rates go up as their Net Interest Margins increase and it’s a positive for cyclical stocks. Keep in mind though, if there is a shock drop, don’t panic. Hold your nerve and don’t sell. It could simply be a correction. If your portfolio if full of quality stocks that have genuine free cash flow, fundamentals will play out and you will have less to worry about.