Interest rates in the US are rising fast. But how fast? The 10-year yield rose 19 basis points over the past quarter to 3.06 per cent. It rose as much again to 3.25 per cent in the first nine days of October. This rapid uplift was sparked by consistently strong employment growth and the realisation that the Federal Reserve believes its federal funds rate is still a long way from neutral.
At 2.25 per cent – widely pegged to be 2.5 per cent by the end of the year – the Fed has upped the pace of its tightening noticeably.
For now, the steep rise in the 10-year yield has boosted the difference between the one-year and 10-year bond yields. Investors had been worrying about the steady decline in this “spread” for months, but from a low of 38bps in August, it leaped above 60bps in early October. This has driven a shift in equity markets, driving the long-suffering value companies higher and pushing growth companies into reverse.
President Donald Trump has been vocal in his belief that the Fed is moving too quickly. As unconventional as Mr Trump’s protests are, we do have some sympathy for his view here. While there have been some wild stories about American truckers getting paid $100,000 (£76,000), we think this is one of a few skills shortages.
Pay cheques are growing barely in line with inflation. We think the Fed must slow down, otherwise it could create a serious setback in the economy and markets.
The cost of capital – how much return shareholders and creditors demand for risking their cash – is rising. That is essentially what is happening when treasury yields rise. This is just one of several costs to have increased. Brent crude at $80 a barrel is almost a fifth higher than at the beginning of the year and the technological cost of being left behind is all too evident.
A long line of failed retailers on both sides of the Atlantic offer an example of what can happen if you adapt poorly to the digital world. Which is why we find it strange that many investors are touting value companies right now.
In the main, these businesses find it harder to pass on higher costs and have slimmer margins to absorb those they can’t. They are usually quite indebted too, meaning steadily rising interest rates will hurt them most. They tend to be the most susceptible to economic downturns.
The best argument for these sorts of companies, to us, is getting bought by private equity and put on the operating table.
Many of them need tremendous investment and reorganisation; dramatic changes that would end dividend payments and ruin operating margin percentages.
This is virtually impossible to do with public shareholders poring over the numbers every quarter. But which ones will get picked off? And at what price? It’s all a bit too much like throwing darts blindfolded for us. If anything, it makes us ponder whether we should be investing in private equity itself.
We said this year would be volatile, and we were right. Broadly speaking, we expected positive returns from equities, but unless you held a narrow part of the US market, we’ve been wrong.
Earnings have risen considerably this year, but price/earnings ratios have dipped. In some respects, it’s quite healthy given the upward move in all markets over the past decade. In others, it’s a little worrying that investors are so sceptical of future earnings.
The treasury market is critical now, we think. Aside from a recent slowdown in property, the US looks very healthy, so it’s hard to see the wheels coming off the economy in the coming six months.
However, if the Fed overdoes its tightening, it could force a recession. Also, there’s an outside chance that China retaliates to American tariffs with the nuclear option: selling its hefty holding of treasuries.
Doing that would boost the supply of US debt, sending the borrowing costs for its government and Western firms significantly higher.
It’s a fiscally fragile time for the US. After splurging on tax cuts, it is burning through 17 per cent more cash than a year ago and issuing more bonds. A sharply higher 10-year yield could cause yet another 10 per cent fall in markets.
While we see this as an outside chance, we have been increasing safe haven assets such as Swiss franc, gold, S&P put contracts and Japanese yen since late last year to protect against such corrections.
David Coombs is Rathbones Multi-Asset Portfolio Funds manager