The equity market rally has continued to gather pace over the past weeks as investor confidence around the economic recovery improved substantially. The MSCI World Index (‘Global Equities’) has delivered a total return of 7.1 per cent up to March 19 in euro terms, a far cry from the -24.4 per cent loss during the same period last year, even though economic activity remains muted due to the curtailment measures in place to control the virus spread.
It is fair to say that the equity market rally that started in November has been built on the expectation of a positive vaccine rollout, leading to a return to some sort of normality by the second half of 2021.
A key debate for investors over the past month has been the rise in inflation and the possible ramifications for equities. The US 10-year Treasury yield rose 60bp since the start of February, peaking at 1.75 per cent on March 18. Rates have been on a steady rise for some time as the global economic expectations started to improve, after bottoming at around 0.5 per cent in July.
The main driver of the uptick in the 10-year Treasury yield from August to January was mainly related to higher inflation expectations. In fact, the breakeven rate on inflation-linked US Treasuries rose 60bp, from 1.6 per cent on July 31, 2020 to 2.1 per cent on January 31. During this period, real rates rose by just seven bp to -0.4 per cent.
This all changed since February as real rates rose by c. 60bp while the breakeven rates rose by just 14bp. Investors are generally more comfortable with a rise in inflation expectations (breakeven rates) rather than a rise in real yields.
This is mainly because equities offer investors protection against inflation as earnings and dividends should rise during periods of rising inflation. Additionally, inflation is more common during periods of economic growth, another positive for equities.
A rise in real rates on the other hand is generally more difficult to digest for equity investors. A rise in real rates has direct implications for the risk-free rate, and, consequentially, for equity market valuations. Bearing in mind the current lofty valuations, we think this concern merits some attention. In that, a higher risk-free rate due to higher real yields implies a higher discount rate, leading to lower valuations.
The main driver of the uptick in the 10-year Treasury yield from August to January was mainly related to higher inflation expectations
In the case of higher risk-free rates driven by higher inflation, the impact on valuations should be neutral as the higher discount rate (due to inflation) is set off by the growth in earnings driven by the same inflation (i.e. in theory, a two per cent increase in inflation should lead to at least a two per cent increase in earnings).
Looking at data since 2016, global equities have delivered an average weekly return of +1.3 per cent against a backdrop of rising breakeven rates and falling real rates. Additionally, returns have been positive 76.6 per cent of the time. The returns were similar during periods of rising inflation expectations and rising real rates, with a similar positive hit rate (+66.0 per cent) and a slightly lower average weekly return (+0.7 per cent). On the other hand, when inflation expectations fell, equities retreated by -0.5% per cent (weekly) on average when real yields rose and by -1.0 per cent (weekly) when real yields fell.
Notwithstanding the above, it should be noted that not all equities are equal when it comes to rising rates and inflation. In our article dated November 22, 2020, we explained our preference for value stocks over growth stocks for 2021. Since then, global value stocks have outperformed their growth counterparts by nearly three times since the Pfizer announcement on November 9, 2020, on a total return basis in euros terms. We reiterate our preference for value over the near-term as we think that these stocks are more exposed to the benefits from the reopening of economies, rising inflation and higher bond yields.
The biggest risk in our view at this stage is a delay in the vaccine rollout especially in Europe. Equity market valuations are currently pricing in a reopening in 2021 and any delay could have a negative impact on the asset class performance. Additionally, at current levels, we caution that the asset class is still exposed to the risk of a correction (as discussed in our article dated January 30).
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Robert Ducker, Senior equity analyst, Curmi and Partners Ltd