Ahead of the curve: The duration bubble
Has the world entered a new paradigm in which growth, inflation and value investing are dead? Various indicators might have us believe this is the case.
One indicator is shown here in figure 1. It shows the monthly performance of a growth index, relative to its long-term trend. Based on Fama-French data, it measures the price performance of the most expensive stocks relative to the cheapest stocks. The extreme divergence between the price performance of expensive stocks versus cheap stocks is apparent during in the period labelled ‘the duration bubble’.
Another indicator is the extraordinary moves in the bond market, which are signalling limited long-term economic growth. Take a look at US 10-year treasury inflation protected securities (TIPS). These are government bonds indexed to inflation to protect investors against rising prices.
With the yield on TIPS at zero it can be further inferred that investors’ expectations regarding economic activity in the US over the next 10 years have collapsed.
Yes, there are headwinds, but to assume no economic growth for the next 10 years seems extreme. In a ‘zero-growth’ environment, one would expect investors to chase yield. But this is not happening. If this was the case, investors would be crowding into high-dividend-yielding stocks like European banks, which have a 7% dividend yield, or any number of other cyclical sectors. They are not.
Instead, investors look like they are chasing duration. That is the amount of time it takes a company to cover its starting valuation with its future cash flows. The higher the starting multiple (or lower the earnings yield), the higher the implied growth or financial leverage in the business, and therefore the higher duration (it will take longer to repay the starting valuation).
When rates approach zero the valuation of long-duration stocks benefits disproportionately relative to the rest of the market. The closer you get to zero, the more extreme this becomes. It is worth emphasising it is not as rates fall, but as rates fall to near zero.
This current environment favours bond proxies and structural growth stocks. The proof is apparent in figure 2. The defensive and growth parts of the market have grown to account for almost half of global market capitalisation. This is the largest it has ever been in almost 35 years. Equities are increasingly behaving like bonds as the market has bid up the price of long duration assets like consumer staples, medical devices, software and internet.
Conversely, the more cyclical parts of the market have become cheap relative to their long-term history. This is despite many of these businesses growing free cash flows at a very respectable rate. These businesses now trade on low multiples, so it does not take long to recover the starting valuation (they have become short-duration assets). This does not mean these businesses are impaired, although we have no doubt in a low-rate environment free money is eroding scale as a barrier to entry. More value traps are likely to emerge
With growth expected to be zero, the market will be sensitive to small beats in economic data. This will not only be bad for bonds but also bond-like equities.
With central banks committed to monetary stimulus and bonds indicating this is a world with no growth, what changes the chase for long-duration assets?
One of the consequences of quantitative easing is that it has stimulated asset prices but not activity, which has led to ever-widening wealth differentials. The consequence of this has been a rise in populism. Growing global populism – apparent in Britain, Italy, Hong Kong and Argentina – has led to a de-rating of European and emerging market equities. But the same risks are building in the US as the election cycle moves into full swing.
A rise in populism leads to protectionist policies – for example, trade wars – and greater regulation, which has a feedback loop into weaker growth and more populism. Central banks respond with monetary policy that increasingly seems to be failing to create demand or encourage banks to lend, and hence feeds more populism.
If monetary policy does not work, where does this lead us? Countries look set to continue moving towards creating fiscal stimulus, as is already apparent in the US. Europe and China have the most dry powder.
Germany used to be the healthy part of Europe but is now underperforming the rest of Europe on account of the global trade slowdown. Germany (and Europe more broadly) may be prepared to loosen its grip now that its economy is heading into a recession, and it has the firepower to stimulate its domestic economy. We have started to hear discussion from European governments regarding stimulus – for example, the Green New Deal – a plan to transition to zero greenhouse gas emissions, which will require a major green-related infrastructure spending cycle.
We think investors should be open-minded to fiscal policy being the answer, and how this may impact the economies that have the firepower to stimulate.
So what needs to be considered when investing in the duration bubble?
● Central bank impotence and the subsequent rise in populism will lead to fiscal stimulus;
● Europe and China have the firepower to stimulate, while European and emerging market domestic exposures are priced for a recession;
● Tailwind from stimulus in the US is fading;
● Long-duration stocks are priced at a premium, while cyclicals are priced for a recession.
We believe true quality and growth is still available, investors just need to look into less obvious parts of the market to find it.
Alison Savas is client portfolio manager at Antipodes Partners