- Real yields
- Market correlates
Real yields are back to their pre-vaccine, pre-reflation/reopening levels of November 2020. We detailed in our most recent note what we think is happening here (growth scares, resurgent flow of daily case rates, see our research blog for more).
W think that real yields of this magnitude are likely not sustainable, and continue to see a US 10 year nominal yield of 2-2.5%.
Rising rates would be a challenge to bonds, albeit we feel a material SAA exposure is well justified on the basis of low-to-negative correlations to equities. However, at the margin, locking in some profits across our diversified fixed income holdings on a DAA basis is appealing.
Particularly given sizeable duration across both the local and international markets (e.g. 6-8 years).
In econometrics, we distinguish between level of rates, and change in level of rates, which are different things. All stocks are negatively correlated to the level of rates, through bog standard valuation techniques like discounted cashflow analysis, however, some stocks are clearly net beneficiaries of the underlying drivers of higher rates, such as improved growth assumptions (discretionary retail), higher expected inflation (commodities), higher term premia (banks) and so on.
We examine this idea below, using correlations of stock excess returns to monthly changes in the 10 year yield, with “cor” representing the most recent 3 year rolling correlation, and “cor wp” representing the whole-of-period correlation.
Bond proxies such as REITs, infrastructure, utilities and gold are all heavily, negatively exposed to a change (higher) in rates, as are secular growth stocks (healthcare, tech).
In part, this modest quant work was a partial driver of our recent decision to exit RMD (ResMed) – the recall issue besetting a competitor was the primary driver (good news rerating the stock) and the positive impact of lower real yields (which we viewed as unsustainable, but convenient to set up our exit) was a secondary push, as it was for TCL (Transurban).
We own several REITs (VCX, DXS) but in aggregate are underweight the sector, and as such are not worried overmuch about our residual rate exposure. We are more inclined to add to the REITs, if COVID should depress their shares again, as we would be similarly happy to own TCL again, at more attractive pricing.
You can also see why we’ve held back from allocating to a stock like Newcrest (NCM) which we regard as a high quality offering in an otherwise beaten up sector, given the view on rates, and NCM’s exposure to changes in real rates.
Turning to the positive correlates, the miners feature prominently. Stocks like Orica (ORI) highlight why we use several windows on the correlations – at first glance the rolling 3 correlation for ORI to rates is negative, however this is a function of recent year woes. A longer time period shown that the correlation is meaningfully positive, as expected, for a downstream commodity play.
Here, Origin, Woodside, QBE, GEM, BHP and the banks underpin our exposure. Where possible, we would look to use COVID to underwrite an entry point into some of the other material rate delta exposures across the ASX 200.
As a small side note, for those wanting to use the correlation tables. The correlations work best when combined into regression models that can control for other important exogenous variables (well, as exogenous as they can be given that everything suffers from endogeneity in markets).
ABC is shown below, with a good factor loading to the change in rates after controlling for FX, oil and level of rates.
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