Uncertainty, risk and investing for retirement
As you are probably aware, there has been a lot of volatility in the last few days regarding the UK Gilt markets. For our clients with relatively high exposure to UK corporate bonds and Gilts, we sold a lot of bonds before this bout of volatility, with a view to protect them from further losses.
The UK Gilts market has attracted the attention of speculators, mainly because of our loose fiscal policy and the fact our Prime Minister and Chancellor do not communicate well, and we think this market will remain volatile, with an increasing yield going forward.
The bank commenced buying up to £5 billion of long-dated gilts (those with a maturity of more than 20 years) on the secondary market for two weeks until 14 October. The bank retained its target of £80 billion in gilt sales per year, and delayed Monday’s commencement of gilt selling — or quantitative tightening — until the end of October. However, some economists believe this is unlikely.
Over the past decade, UK defined benefit pension funds have turned to liability-driven investment (LDI) strategies to help match their liabilities with their assets, often using derivatives. These derivatives had as collateral Gilts owned by the Defined benefit pension funds. As the value of the 30-year Gilt dropped by 60%, these pension schemes have received margin calls and in need of liquidity, some having to sell other Gilts or growth assets to meet the margin calls. We thought people learned something about leverage and derivatives from the previous Global Financial Crisis (GFC), but it seems some did not.
There is better news from the United States. Jeremy Powell is doing a good job at fighting inflation and made it clear on 26 August that “the FED will keep at it until it gets the job done”, referring at the fight with inflation. This is when we made the decision to sell high volumes of bonds for clients. He used the same words used in 1979 by Paul Volcker, the FED chairman from 1978 till 1987 – “we are keeping at it, until we break the back of inflation”. In the process, he needed to increase interest rates to 20% per annum, generating a double dip recession too in the process (1980, and 1982), but after that the FED kept the U.S. inflation at bay until the end of 2020, without the need to increase interest rates more than 6% per annum again.
In the U.S. sales of automobile were up in August by around 11% compared with August 2021, however expectations are that auto sales may tail off from September. Tesla remains one of the firms with the high increases in sales, expected to continue its sales grow till the end of the year. Interest rates used for borrowing for a new car (a person with a good credit rating) are moving up slightly, reaching 5.9% per annum. Auto-makers pay their lenders / bondholders around 5.2% per annum for buying their 5-6 years bonds.
In short, we have the FED tightening its monetary policy both by raising interest rates and reducing the money and credit, however, U.S. and U.K. banks still have 3x – 4x reserve with Central Banks so they can lend unlimited. People are still borrowing and have not stopped, now most people see inflation as something they could take advantage of, and borrow and buy expensive goods, thinking they could repay the loans at inflation rates higher than inflation. As demand increases and supply is not yet there, this would keep inflation going, requesting Central Banks to put interest rates even higher. This shows how hard is to fight a supply induced inflation using monetary measures.
The maths for gravity
Many investors do not quite understand how discounting works. To keep things simple, I will use the net earnings and yield as a proxy for the free cash-flow of a security. The stock price is the present value of all free cashflows received from a security, discounted by a long-term interest / discount rate.
Equities and equity like investments
This will cover both equities, but also equity like investments such as infrastructure or property, where there is both yield variability and asset price volatility. I would split this as follows:
1. The boring company – this is the company which always trades at a low Price to earnings ratio (P/E ratio). It is expected to die or disappear at some time in the future, examples could be Oil companies, some old healthcare companies, industrials of the past, utilities in countries with high regulation (France, Germany, etc.), some consumer staples with no brand, competing on price, etc.
Before the increase in interest rates, their net earnings were either going down slightly, but for most keeping level in nominal terms or even keeping with inflation i.e. increasing 1% - 2% per annum at most. In 2021 the inflation expectation and long-term U.S. Treasuries were at 2% per annum. With an equity premium of 7%, discount rates were at 9% per annum for the market (S&P 500) in 2021.
As these companies are more volatile investors would require a 10% per annum discount rate, giving these companies a P/E ratio of 12.6x for 2021. Not all traded at this ratio, but on average around this figure, especially when using net earnings averaged over a few years.
The long-term U.S. Treasury yield has increased to 3.7%, long-term bonds yield is also a measure of inflation expectation. If in my spreadsheet I increased the net earnings growth to 3.5% for long term and discount rate to 10.7% however with 10% earnings increases for the first two years – as a result the P/E ratio will remain at 13x, applicable to an E (earnings) higher by 10%. As a result, the stock prices of these companies have gone up by around 15% so far.
A sub-category are the miners and oil and gas companies for which prices of ore, oil and gas are very volatile, and these were at around P/E ratio of 10x before. Because their earnings could double for a few years, it is not uncommon that in periods like this to see their stock up by 50% to 100% and find them now at a P/E ratio of 5x or 6x, based on the very high net earnings from July 2021 – June 2022.
In short, for these companies, as they can increase their revenue easily with inflation and usually more, increases in interest rates do not affect their stock prices by much, for the majority an expectation of higher inflation, and earnings increasing well above inflation, would send the stock prices up significantly.
2. The quality company – this is the company which has some sort of a moat (oligopoly), it is usually a younger healthcare company, a consumer staples or consumer discretionary with a good brand, some industrials and tech companies, even some utilities. These companies used to trade in December 2021 at P/E ratios of over 25x, some as high as 35x, having earnings increases between 5% to 7% over the long term due to growth in sales and future increases in margins. A change in discount rate from 7% to 10% with a limited expected increase in earnings due to inflation would take a high-quality company like Microsoft or Alphabet down from 35x to 23.6x, a 33% fall in the stock price.
3. The growth company – this is the company that was expected to grow at very high rates, something like over 15% per annum for the next 5 to 10 years, some at over 30% or 40% over the next few years. Two things happened to these companies:
a. some do not grow as much as in 2020 and 2021, when the high growth was due to the pandemic, and they are still losing money, as a result they have lost anything between 50% to 80% of the value of their shares; (DocuSign, Zoom, Peloton, etc)
b. others which are barely profitable (Etsy Inc, Crowdstrike Holdings, Veeva Systems, Tesla, etc.) which used to trade at a P/E ratio of 50x to 160x have lost around 30% to 50% in value, due to the higher discount rate.
4. The “new” company – this is usual a biotech company but could also be a new tech or defence company. The company still loses money, although some could be profitable. Their sales are not sensitive to the business cycle, more important is the probability that they will come up with a working molecule, or product accepted by the client (Government) or market, etc. Because of this, the discount rate does not influence their stock price at all. Example: biotech companies like Argenx SE or BioMarin Pharma, Palantir Tech, a technology company working for the U.S. and U.K. Government in the “big data” sector, some small defence companies, etc.
5. The infrastructure company – this is usually a company which invests in assets which produce an income: commercial and residential property, airports, toll roads, renewal energy solar panels and windmills, antennas, canals, prisons, etc. Most likely the income is negotiated many years in advance, and it increases with inflation as measured by CPI. Small increases in interest rates and higher expectation of higher inflation were initially helping these stock prices for these companies, however higher increases in discount rates would make the gravity effect present for them, especially as some are purchased with borrowing; an added risk is that contracts could end earlier due to tenants falling into administration, etc., and the negotiated rents would be lower.
Initially the stock went up 30%, but retreated around 12%, and would go lower in case of future discount rate increases.
Fixed income
For fixed income funds and security, as the pay-outs (cashflows) are already known in the future, the discount rate increase reduces the Present Value (PV) of the securities. The effect is measured by calculating the modified duration for each security or fund. For a fixed income security with a duration of 4 years, an increase of 1% in interest rates would reduce the price of the security by 4%.
Conclusions:
1. There are not many places to hide from increases in interest rates, apart from some commodity producers (oil and gas, agriculture, etc.) and biotech. We need to embrace gravity.
2. There are different discount rates in use, for fixed income securities with redemption in the next 5 to 7 years and boring companies, usually the shorter Treasuries rates are used, to discount free cashflow for the next 5 – 7 years paid out. For high quality and growth companies, and for infrastructure companies, and for long duration fixed income securities, including Index-linked securities, longer interest rates are used because the free cashflows are well into the future.
3. We expect that with higher increases for rates from Central Banks, the yield curve to move up asymmetrically, something that has started to happen already. As a result, a 0.5% increase in short duration rates would result in 0.15% to 0.25% increases in long duration interest rates i.e. the discount rate used for high quality, growth and infrastructure companies. So, we could soon be investing in these companies again.
4. Consumer confidence is very low. In the past when this was as low as now, in 67% of times the stock market has rebounded in the next 12 months. This could happen in the case of a recession, together with a reduction in inflation forcing the FED to change tack and start decreasing interest rates. Also, an end in the Ukrainian war could make stock market rebound and inflation subside. Even a 0.25% reduction in interest rates from FED could send stock markets up by double digits. This makes timing the market very, very difficult.
IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.
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