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In today’s increasingly inter-connected world, financial markets are notoriously correlated across regions as well as asset classes. It is therefore key for investors to take a wide view of the impact of changes in economic variables on your portfolio.
Today we find ourselves in quite a rare situation from a historical point of view. The US economy is arguably further along in the economic cycle than its’ European counterparts, where interest rate hikes are tangible and programmed, and an economy which is firing at higher growth rates. Across the pond, as the outlook for European economies improves, the tone in the most recent ECB meeting has only just started to change, but an indication of when interest rate hikes will actually arrive remains elusive.
Economists are debating that the increase in US treasury yields is already changing the landscape for global investors. There is increased talk of a “great rotation” from equities back to bonds once 10-Year US bond yields breach the 3.5-4% level, as the risk-reward profile changes. The reasoning behind this is that the dividend yield on US equities is becoming comparatively less attractive. In fact the long bull-run in the equity market has been in part attributed to the low yield environment.
As yields rise, valuations fall as the cost of access to capital increases, reducing the ability or willingness of investing in new projects and/or upgrading infrastructure. A counter argument to this however, is that if interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium. This argument is currently supported by very strong earnings results reported by companies. The general consensus is that higher interest rates generally aren’t favourable to companies, and equity investors alike over the long term. As the situation unravels over time investors can expect uncertainty and increased volatility to return to the equity markets.
Another component of your portfolio which is affected by bond yields is real estate. Many investors, especially locally, have flocked to real estate investments in order to generate the yields they were deprived from other asset classes. As yields rise, the business case for investment in real estate weakens, having a negative effect on price. Although this is not expected in the near future in Europe, the situation in the US is a different one and could have a knock-on effect across asset classes.
Given the inverse relationship between yields and prices of bonds, and the continued attractiveness of bond investments given the known cashflows which are received, the advice in a portfolio context is simple. Where the context is for yields to rise in the future, when investing in bonds, keep duration (the length of time until maturity) short in order to minimise the negative interim fluctuations in your principal. Also, be wary of companies with weak credit metrics, as if they are forced to re-finance at high rates it may make their balance sheet unsustainable.
The interesting quandary at the moment is, although the US and the EU are at different stages of their cycles, and the likelihood as well as magnitude of yield increases are materially different, as intimated above we live in a highly correlated world where there is no insulation to any shocks emanating from the US. Therefore, for European investments the threat may currently not be increasing yields, but investors shouldn’t discount what is happening across the globe and its potential impact on their valuations.
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