The Potential Impacts of Interest Rate Re-Normalization

I tend to think credit spread widening would be transitory this early in an economic cycle but create a volatility episode.

Re-normalization of interest rates back to pre-pandemic levels could create valuation risk for three types of stocks:

1. “Speculative fringe” growth stocks,
2. bond-proxy stocks in places like staples, REITs, some parts of health care, and
3. financial engineering plays such as Special Purpose Acquisition Companies (SPACs)

These stocks have benefited from an infinite duration and loose-money indefinitely mindset that has prevailed during the pandemic, fueling a speculative burst.  Alternative forms of money, such as Bitcoin and Gold also have benefited from this phenomenon.  The pandemic and economic lockdown appear poised to end in 2Q, and rates to a large extent are signaling this.  Higher yields argue for better earnings results in more asset-driven businesses such as industrials, materials, or interest-sensitive financials.  The broader market is not at a demanding level at current yields (US 10 Year Treasury is at 1.3%)^I or prospective yields in 2021 (it would not be a big stretch to see the 10 year back to 2.0% by Christmas).  Investors may need to reposition further than they have in particular as they have rationalized very aggressive valuations based on a “there is no alternative” mindset. As yields tick up, even if they are still pretty dang low, there is an alternative…

There is a reasonable possibility that as nominal U.S. Treasury yields rise, particularly above the 1.5% level, that credit spreads re-price a bit wider (they are currently very low) and this would probably hit the overall stock market.  I tend to think credit spread widening would be transitory this early in an economic cycle but create a volatility episode.  Importantly, few investors take the notion of a durably higher inflationary cycle seriously, as globalization, digitalization, and low population growth remain persistent realities.

The impact of new tech remains profound and disruptive, creating real issues for the value of commercial office space as remote work and remote conferencing seems like durable productivity enhancements.  Likewise, new industrial realities driven by technology, such as electric vehicles replacing internal combustion engine autos, may impact credit-worthiness in a variety of companies and jurisdictions.  This has yet to really hit the credit cycle, but could.

The bigger question over the next 24 months is how will central banks and markets respond as we get an inflationary bulge that is the result of pent-up demand, immense liquidity, supply chain challenges, a low base-effect, and other fundamental changes in the economy?  The Fed claims they will look through it, and to some extent the Fed and other central banks want inflation to break higher than 2% to make up for past undershooting and to re-arm themselves with conventional interest rate weaponry.  Markets may or may not be so charitable; for the time being, they continue to price the inflation threat as benign but have to acknowledge at some level that the Central Banks intend to dilute the value of fixed income claims.  We have entered a much different phase in terms of public sector debts globally – these appear to be tolerated as a logical consequence of aging demographics, digitalization, and globalization.  Unlike the post-2008 Global Financial Crisis (GFC) period, where fiscal spending was not overtly monetized, that seal is a lot looser now.  The other big question is whether the USA, China, etc. will pursue growth or anti-growth policies once the economy re-opens.  Hard to say what the answers to any of these questions ought to be right now.

THE LONG DURATION ISSUE 

Stock market valuations and bond yield trends have held an inverse relationship for the last 20 years.  Falling yields have entailed less confidence in the economy, while rising yields have entailed more confidence and therefore a better earnings and stock market outlook, broadly speaking.  Inflationary pressure can be the cause of rising bond yields but there has not been a durable inflationary pressure episode in the 21st century – the cyclical inflations in housing and commodities were bubbles and popped.  The opposite has been true, more deflationary pressure than inflationary pressure, due to the combination of digitalization and globalization in the overall world economy, such that yields have fallen persistently.  Because the trend has been towards disinflation if not outright deflation, the so-called “neutral” interest rate has proven to be a very low number, money velocity has fallen persistently, and Central Banks have needed to augment their balance sheets to sustain economic activity and systemic liquidity.  These phenomena have led to a high stock market concentration in “long duration” stocks, such as core growth names like the FANGs, and more speculative growth names like Tesla, Paypal, Peloton, etc.  If core inflation became a real thing again, i.e. 3%+ inflation, these kinds of businesses probably need to reprice lower, i.e. duration needs to be shorter for all financial instruments.  Right now, I am not able to predict something like that and am somewhat doubtful due to the potent forces of digitalization, globalization, and low population growth, but it’s not a possibility that you can exclude completely.

Brian M. Barish, CFA

Brian Barish is the President and CIO at Cambiar Investors and is responsible for the oversight of all investment functions…