Turning to the bond markets for clues

GLOBAL equities closed strongly last week, thanks to the strong showing by markets in US and Europe. You might have recently heard that certain stocks tend not to do well during periods of rising yields. Why do some stocks love them, and others hate them? The speed by which yields are rising as well as the shape and co-movement of the different parts of the yield curve, may provide clues.

Before we get there, firstly, it is important to understand how stocks are valued. The fundamental basis of stock valuation begins with valuing its projected cash flow over a foreseeable investment horizon. This future cash flow is discounted back to the present by its cost of capital, which is influenced by the risk-free yield of a government bond.

Growth: Stocks that benefit from lower rates

Lower rates generally reduce the cost of capital for businesses. Therefore, stocks that aggressively expand their businesses into high growth areas through cheap financing, often have higher growth premiums built into their prices.

Stocks with high future potential are colloquially termed as growth stocks. A large number of growth stocks today are loss-making. Investors buy them with an expectation that their exponential growth rates would translate into rising earnings well into the future. Mathematically, much of the value assigned to such stocks is based on their projected cash flows 10 or even 15 years ahead.

Just like the 10 and 30-year government bond yields, such stocks are considered as "long duration" assets, because it takes a long period for these projected cash flows to be paid back to the investor.

Thus, "long duration" assets like growth stocks are highly sensitive to changes in the long-term yields, similar to how the price of a 10-year bond moves disproportionately relative to a one-year bond, whenever there is a move in interest rates.

Over the past one year, the best performing retail unit trusts in Singapore have been strategies that focused on investing in hyper-growth companies across the green energy and disruptive innovation complex.

Both the Nikko AM ARK Disruptive Innovation B SGD and the BNP Paribas Energy Transition Classic USD rewarded investors with total returns of 151.36 per cent and 277.85 per cent, respectively, over one year ending March 31, 2021. Prior to the sell-off in growth stocks, at their peak, these investors' returns would have been much higher at 227.47 per cent and 344.52 per cent respectively, for the period between end-March 2020 and Feb 15, 2021.

Value: Stocks that benefit from higher rates

Different stocks have varying levels of duration exposure. If we go back to the example of how companies are valued, established businesses with recurring cash flows and moderating growth rates tend to exhibit lower duration characteristics.

Economically-sensitive stocks belong in the value category. The potential cash flows of such companies are more dependent on the underlying trajectory of the business cycle, as their earnings expand and contract in line with it. Given the greater visibility of their earnings, movement in yields have a smaller impact on value stocks.

An example of a sector that has value attributes is the financials sector. Banks and insurance companies, in short, make money by borrowing short term and lending long term. They make more or less money as the spread between the short and long term yields widens or narrows.

When economic activities expand and yields rise, it generally means that they can generate higher potential earnings as the current business cycle picks up, since rising net interest margins, higher number of loans, and lower loan loss provisions are likely to follow. As their earnings tend to be more visible, financial stocks exhibit lower duration characteristics.

In fact, such trends are playing out as we write; unit trusts that invests predominantly in value-oriented stocks have outperformed growth in 2021. The divergent performance between growth and value-oriented strategies highlights this point.

On a trailing year basis, while the Fidelity Global Financial Services A-ACC-SGD has underperformed funds like Nikko AM ARK Disruptive Innovation B SGD by about 100 percentage points, it has outperformed the latter by around 20 percentage points over the last three months (as at March 31, 2021).

Yield curve provides clues

We can infer a number of things from the yield curve alone. The first thing to note is the broad consensus that the Federal Reserve would not hike rates until 2023, based on the chart (below), which shows a higher yield priced into markets for two-year treasury bonds.

Chart 1: For now, the market has provided its verdict of no secular inflation

Another thing to note is the broad steepening of the entire curve beyond two years. The steepening of the 2s-10s term spread (yield difference between a 10-year and 2-year treasury bond) by 50 bps is evidence of an improving medium term growth and inflation outlook.

The steepening should not come as a surprise given the current narrative of rising inflationary pressures, stemming from bottlenecked supply chains, higher commodity prices, and the increasing likelihood of greater fiscal stimulus, as well as the gradual normalisation of economic activities globally.

While the 2s-10s informs us of near to medium term inflationary pressures, the 10s-30s is suggestive of the longer-term inflation picture. Contrary to what was observed in 2s-10s, the change in term spread for the 10s-30s (as at April 2, 2021) for Q1 2021 was -10bps. This spread should have widened if secular inflation was the market's base case expectation.

What this means for your portfolio

Despite what the current narrative suggests, growth stocks still have a role to play in your portfolio. Under the current assumption of transient inflation as implied by the 10-30s term spread, the beaten-down valuations of growth stocks provide a good entry opportunity for value-conscious investors.

But I would only go as far as buying large cap growth stocks - the likes of Microsoft, Alphabet, Visa and Amazon, as they have the advantage of being highly cash generative. I would be cautious on small to mid-cap growth stocks.

Hyper growth stocks have additional hurdles to clear to convince market participants that profitability would come sooner rather than later, which grows increasingly important if yields continue inching higher. Therefore, my choice of unit trust in this case is the Wells Fargo US Large Cap Growth Fund Cl A Acc USD.

On the other hand, I continue to believe the global recovery narrative remains intact, and that investors would be remiss to avoid value stocks especially after its big run. Idiosyncratic risks aside, I continue to favour regions like Latin America given the cyclical make-up of its economy. As for sectors, financials remain a good expression of rising growth expectations which would feed into higher earnings over the coming quarters.

To sum things up, it would appear that style agnosticism for investors' portfolios may be an ideal stance moving forward. 2021's broad-based economic recovery is a rising tide that lifts most boats, and investors should seek to capture opportunities across the entire equity spectrum. In the event that the market is wrong, such that growth or inflation is headed lower and not higher, investors at the very least are appropriately diversified.