Evenlode Investment View - April 2010

Rock Bottom Rates

For investors in search of an attractive return on their savings, today’s cash and bond markets resemble a barren lunar landscape. Wherever you look, yields have come down sharply. Interest rates in most of the world are rock bottom. While government bond yields have risen somewhat in recent weeks, they still reside at close to a 25 year low point. It is hard to believe it now, but back in the early 1980s, government bonds offered a long-term yield well into the double-digits for anyone willing to take the plunge. We are a world away from that now.

The corporate bond market, thanks to its incredible rally over the last year, doesn’t offer much more in the way of yield either anymore. No better demonstration is the Merrill Lynch US Financial Corporate Bond Index. This index is comprised of bonds issued by many of the US financial institutions that teetered on the brink at the height of the crisis. It offered a premium over US treasury yields of 8.4% just over a year ago, but now offers a miniscule 2.2% over and above government bonds. It is difficult to argue that such a meagre and fixed reward with no ability to protect against inflation compensates for the risk of owning the debt of these highly leveraged companies. Non-financial bond yields are even lower, with some high quality US corporate bonds trading at lower yields than US government bonds. Even PIMCO’s Bill Gross, manager of the largest bond fund in the world, readily concedes that bond markets have seen their best days for now.

So are rock bottom interest rates and bond yields good or bad for the stock market? My answer would be good in the short-term but bad in the medium-term. They are certainly helping the stock market at the moment, making today’s equity valuations look very appealing on a relative basis. To illustrate, the average earnings yield on a UK blue-chip share (i.e. the pre-tax ‘interest rate’ it pays you) is more than 8%*. Not a bad 'bank account' with UK base rates at 0.5% and UK gilts yielding approximately 4%, particularly given that this 8% ‘interest rate’ should grow over time and help protect against inflation, something cash and bonds can’t promise.

This valuation differential is fuel to the current market rally and while central banks continue to leave the monetary spigots wide open, the fuel continues to be shovelled on. However, with interest rates stuck at such extreme artificial lows, inflationary pressures are building - rates could have a long way to go when they do start moving upward. Government bond yields are likely to begin rising earlier than base rates, and potentially have even further to go as bond investors demand higher yields to compensate for growing risks of sovereign default. A significant move upward in UK gilts yields and ultimately UK base rates – both very likely in the medium term - will act as a strong headwind for stock market valuations.

I expect this transition - to a world of higher interest rates, bond yields and inflation - to be one of the key investment challenges of the next few years - even if it takes some time to reveal itself given the current disinflationary pressures. Owning shares on high earnings yields (i.e. that already pay a high ‘interest rate’) with pricing power and growth potential will be a key part of managing this transition. As I have said before, what I am finding particularly interesting currently is that many of the stocks that possess these latter two characteristics (such as consumer staples and heathcare companies) also happen to be trading on attractive earnings yields versus the overall market. Shares to avoid will include indebted and capital heavy businesses – higher interest rates and inflation will mean their cash flow is largely absorbed by interest payments and capital expenditure. Stocks on low earnings yields (i.e. that pay a low ‘interest rate’) will also suffer as they look increasingly unattractive relative to bond yields and cash-in-the-bank. Simply put, a combination of value, quality and growth will be essential as yields begin to rise.

Hugh Yarrow
1st April 2010

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st April 2010 and does not constitute investment advice.

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