Friday Morning Coffee Nr. 8: Messages from the bond market

270418 Friday Morning Coffee

Friday Morning Coffee Nr. 8: Messages from the bond market

So now it is official: we broke this week through the 3% yield on the 10 Year US Treasury. And strangely enough, even in Luxembourg, the sun rose this morning and we are still alive! So I wonder, like probably most equity portfolio managers, what Mr. Bond market wants to tell us: are we in for trouble due to rising yields or is this a storm in a teacup?   If we take a step back to 2013 and the start of the Fed Taper (reduction in US asset purchases), US bond yields actually doubled from 1.5% to 3% over the following six months and German bond yields hit 2%. How did Mr. Equity Market react then? Stocks quickly rebounded following the initial weakness as can be seen below… Source: Bloomberg, ECP. Past performance is no guarantee for future results.   So what is different today? Yields may now once again be at 3% but we now also have global growth synchronization. Economies are growing and inflation expectations are still relatively subdued, more so in Europe, as the European Central Bank is not yet in tightening mode. To us, the reaction from the bond market in Europe shows that Europe and the US are on different points of the business cycle which fully corresponds to what we see on the ground.   As value investors in Europe, we are also not too concerned about rising yields, at least not yet. We deem them as a side effect of the normalization process as central banks progressively withdraw their extraordinary quantitative easing measures. The economic growth engine is humming again and deflation is no longer a subject.   Different factors actually play into our hands as value investors in European Equities:
  1. We are convinced higher US rates will ultimately lead to a higher USD, taking away some of the pressure European exporters are facing.
  2. We typically invest in companies with strong balance sheets that are less vulnerable to rising rates. To be concrete, it currently takes the median company in our portfolio less than a year to pay back its debt.
  3. Rising bond yields are typically good for value strategies against momentum or growth styles as value stocks have a shorter duration (refer to our 2nd Morning Coffee published on March 16th).
  4. Our focus on earnings power, i.e. cash flow generation, differentiates us from other investors who focus on high dividend yield stocks that are vulnerable to rising rates and are therefore uncompetitive against bonds.
  5. European equities are still not overly expensive to us.
  There is a caveat however to what we stated above: we believe that if interest rates would continue to creep up and stay at sensitively higher levels (above 4% for example), equity investors will more than likely feel the heat.   So we continue to watch our inbox for messages from Mr. Bond Market …