Episode Transcript
[00:00:00] The Finance Ghost: The markets. We just can't get enough of them.
[00:00:03] Mohammed Nalla: Markets are the drivers of your wealth and investment strategy.
[00:00:07] The Finance Ghost: Welcome to Magic Markets with your co-hosts, The Finance Ghost and Mohammed Nalla.
[00:00:13] Mohammed Nalla: Together we have more than 25 years of combined experience in the markets.
[00:00:18] The Finance Ghost: Looking to take your market knowledge to the next level? Well, you are certainly in the right place. And you should also check out Magic Markets Premium, our weekly research report and podcast covering global stocks. It is still just 99 rand a month or 990 rand for the year and features literally a couple of hundred reports and podcasts on international companies. This is an incredible resource for any stock picker.
Welcome to episode 274 of Magic Markets, where my good friend and co-host Mohammed Nalla has unfortunately gotten on the wrong side of a pothole. Now, those of you who have been listening to the show for a long time will know that he lives in Canada, so that may come as a strong surprise to you.
Mo, you may well be the only person in history who has left Johannesburg, moved to Canada, and then had the pothole experience anyway, so that is most unfortunate. I'm sorry to hear this.
[00:01:04] Mohammed Nalla: Yeah, Ghost, I'm chuckling because, you know, our potholes are bad enough to damage a set of tyres, sure, no problem. But they're not the massive water features or, let's call them, mini lakes that you get up in Johannesburg.
Spring is probably the worst season up here for potholes. The ice from the last season cracks open the road and they haven't had time to repair it. Unfortunately, that's how I've started my week. So let's move on to better stuff and more interesting stuff, because there's a lot to talk about in the market.
[00:01:27] The Finance Ghost: No, absolutely. There's plenty to talk about. And in Canada, you probably don't have politicians busy doing PR campaigns on rubber duckies in your potholes.
But what you do have up there in North America, certainly in the US — I'm not sure about Canada, but he'll tell us — is bond yields that seem to be rising all of a sudden, I suppose. I don't know if that's fair to say or not, but definitely it made it into the headlines in a big way over the weekend.
And that is worth talking about because it has a lot of impact on equities, as we'll discuss on the show. But before we do that, I think let's just understand what actually drives bond yields. Inflation, that's one of the factors, sure. A change in inflation expectations, that's a particularly big factor. But there's a lot more, right, that leads to why a 10-year yield or a 5-year or a 20-year, whatever it would be, is at a particular level.
[00:02:12] Mohammed Nalla: It hasn't really happened suddenly. I think it's been creeping up, and I'll unpack some of that in our discussion. It's certainly gotten to levels where now it's hit the headlines, people are starting to notice. And when you see that move higher in bond yields in the US, it naturally filters through to global bond yields, because the US 10-year, if you want to call it that, is the de facto risk-free rate internationally.
Let's jump into that, because what moves bond yield? Maybe before we even do that, Ghost, I want to almost land on what my key takeaways are, because I want that to be the kind of core message that runs through the show, and then we unpack how I get to that, right.
Bond yields are effectively the price of money. And when that price of money moves higher, every single asset has to be repriced. Equities are priced off that. We can unpack how you look at that.
But the second point is that not all yield moves are created equal. I mean, we've actually seen this move higher in the US bond curve. You've seen it on the 10-year, you've actually seen more pressure at the longer end, at the 30-year.
But the point is, what's moving the yields? Because if yields move because of growth being strong, equities can kind of handle that. But if they move because of inflation fears around oil, that kind of thing, it's a much tougher setup.
And then I think the third point is really around equities. What does this mean for you when you're seeing bond yields move higher? Because a lot of people struggle to contextualise that into what's happening in the equity market. And for me, people think around duration when you're talking around a fixed income portfolio, but that same thinking applies to equity.
So let me directly answer your question. What's driving the bond yields? Yes, inflation. That's the obvious starting point. But bond yields are not just a scorecard of what's happening on inflation. It's effectively forward-looking. It tells you what the market is thinking around inflation, growth, central bank policy risks.
I mean, we've just had the confirmation of Kevin Warsh as the incoming Fed chair, some risks around that, and then what that will look like over the life of that bond. So if it's 10 years, it's effectively a view on rates, inflation, all of that over a 10-year time period.
So if we unpack that, the first is expected inflation. If investors think inflation is going to be higher in the future, they're going to demand higher yields today. And that is why what we're seeing in the oil markets at the moment matters so much.
Because if energy prices are rising because of geopolitical risks around the Middle East and so forth, the markets then worry that that inflation stickiness could actually become embedded and then accelerate through second-round effects.
Now, if we look at where expectations are currently calibrated, they're currently running at around 3% to 3.5% at the five-year point in the US. That's where people expect inflation to be. But the near-term inflation expectations, that's the concern — they're currently running at about 4.5%.
Now, for context, remember the Fed's target is 2%. So even at the more muted five-year levels, you're still running significantly hotter than the Fed's stated policy actually implies. And I think that near-term fear around oil, around second-round effects, that's really driving some of the shorter-term movement.
Then the second point would be real interest rates. Because if people think inflation is going to run hot, they want to be compensated for that. If we look at what's driving that, what's the growth story, right?
If you look at the US, the labour market's still firm. And if you look at unemployment rates there, they're around 4.3%. It's not quite where we were before the pandemic, but they are running at these multi-decade lows. So it is a labour market that's running hot.
The US growth story has been quite resilient. And so if people are saying growth's quite strong, inflation is running hot, the policy response there would be one of higher rates because you can actually increase interest rates without compromising the growth story. So that's that dynamic.
Third one is actually term premium. It's one we've spoken about on the show. It's one I focus a lot on over the longer term. And what is that? It's effectively: are you compensated for holding the much longer-dated bonds that are out there?
And for context here, if you look at the gap between, let's say, the US 30-year — that's what mortgages actually peg against — versus the US 10-year, which is kind of more of the benchmark mark, we actually went from being inverted at around 1.5%, 150 basis points — we were inverted, let's call it around 18 months ago, maybe two years ago — it's moved from that into around 1.4%, or 140 basis points positive.
So that tells you that the yield curve has switched around quite a bit. There's a lot of term premium coming into that, and that's really related to a number of factors. But I would say fiscal risks in the US — lots of spending — can the government actually afford that over the longer term? And what's happening with their deficits? All of that starts to come through in terms of a term premium being compensated more for holding the longer-duration assets.
And then lastly, just overall growth and risk appetite, because strong growth can push yields higher, because it reduces the need for rate cuts. We've discussed the kind of oil dynamic coming in there.
If I summarise all of that, yields are currently being pushed around by expected inflation, near term, certainly oil a big component of that, term premium — we've discussed the fiscal risks — as well as the fact that, ironically, the US growth story has been running quite hot.
And because it's not one clean story, it actually makes it quite a complex backdrop, because that then filters through into the entire financial system. What is your scenario planning?
Now that I've dealt with the drivers of those bond yields, I want you, Ghost, to link that back into what it means for equity markets, because a lot of our listeners are focused on equity markets. When bond yields rise, why does that matter so much for equities? Which stocks are affected and how does it actually filter through into the valuation story?
[00:07:23] The Finance Ghost: Thanks, Mo. And it is really important because that is how it hits most of us directly in our portfolios.
And the beauty of the pandemic — it didn't have too many highlights — but one of them is that we got this masterclass in what happens when rates go all the way down very quickly. And then we also saw what happens when they come back up really quickly.
And you might recall stocks like Zoom, etc. We were always quite good in Magic Markets Premium to highlight how frothy these valuations were. Cathie Wood, when she was all over the media buying up these frothy tech stocks — what do those stocks all have in common? Well, they were intending to make all of their money 10, 15, 20 years in the future. It was all about the terminal value.
The world is going to change forever. No one's ever going to meet in person again. We're all going to use Zoom now. Unfortunately for Zoom, that is not what's happened. Also, we are using a lot of video calls these days, but there's way more to the world than just Zoom. And therein lies the problem.
In a low-rate environment, where the money is cheap, you have people chasing after these assets that have big promises about money that might be made very far in the future. And that's because people are not so worried about inflation. They're not so worried about the cost of money, and so they're willing to roll the dice.
When that starts to change and rates go up and money gets more expensive, then you have this washing away of some of the hot money in the market. That's the one element that hurts these stocks.
There's another element, and it just comes down to finance theory. It's as simple as that. The main method that still drives the valuations of companies, even the tech stocks, is discounted cash flow analysis.
If you don't believe that, you just have to look at what's happened to the hyperscalers other than Alphabet — the really big names in tech. Why are they under pressure? Because they're not returning as much cash to shareholders. They are busy sending gazillions and gazillions of dollars up the value chain towards the likes of Nvidia and away from companies like Microsoft, like Amazon.
So discounted cash flow analysis remains a major source of valuation. And the base principle is that the further in the future that you will find a particular cash flow, the more sensitive it is to the interest rate that you use to bring it back to today's money.
And so as bond yields go up, your risk-free rate also goes up. And that is the key component of the rate that you use to discount those cash flows. Because what you would do in practice is you would put an equity premium on top of the risk-free rate, and then you would bring that back.
In South Africa, as a really good example, you've got a risk-free rate that is normally around 9%, 10%. Bond yields vary. And then you've got an equity risk premium of maybe 5%, 6% that gets put on top of that.
And so cash flows for an average-risk company — and there are lots of important professional judgment calls that go into whether or not something is average risk — but you would typically use 14%, 15%, maybe 16% at the top end for cash flows.
So if that changes, then it makes a big difference to cash flows far in the future. And in developed markets, as a final point, it's actually even more sensitive because the rates are just lower, right?
So an interest rate moving 50 or 100 basis points when the base rate is 3% or 4%, that's very different to 50 or 100 basis points, or the SARB's favourite little 25 basis points chipping away at the marble on our base rate.
Because just think about it logically — it's like the analogy of a child, right? A four-year-old is 33% older than a three-year-old, but it's only one year difference. It's the same in bond yields, in interest rates.
So to answer the question, what gets hurt the most when yields go up would be all very frothy stocks with long-duration cash flows. If you don't believe us, go and have a look at Cathie Wood's fund. Go and have a look at some of those stocks. Go and look at Zoom. There's lots of examples.
That's what happened to them in the aftermath of the pandemic when rates started to rise. It gets nasty very quickly, Mo. That's essentially how these things work.
[00:10:58] Mohammed Nalla: I love your analogy in terms of the base effect, because yeah, in developed markets, when you had a swing of, let's say, 50 or 70 basis points, as we've seen from the kind of lows we've had to where we are right now, that's really material in terms of that discount factor. Yeah, that really does move the needle quite a lot when it comes to valuations and what you actually price into that discount factor.
[00:11:19] The Finance Ghost: No, it does, absolutely. And Mo, something you highlighted earlier is that inflation in the US is running higher than target. And I think that's an important point that we need to maybe finish off on.
Because here's the really hard question, right? Are yields only just beginning their upswing? Are they going to maybe calm down? Obviously it's impossible to know for sure, clearly, but there's a lot going on here. There's oil price expectations, there's a conflict in Iran, there's the macroeconomic stuff, there's the geopolitics, there's the fact that Trump would like rates to be lower.
Take us home, paint the picture for us. How high can US bond yields go? And then on top of that, because I know you do a lot of institutional work in this space from an equity sector perspective and the rotations in this scenario, where do you think the capital is going to go and where's it going to run away from?
[00:12:01] Mohammed Nalla: Wow, that's the real juice. Those are the tough questions. I'm going to go dig my crystal ball out of a pothole on a Canadian highway and see what we can come up with.
If yields are going up because we've got growth, equities can live with that. That's not a bad story. But if it's the oil, if it's inflation, the fiscal deficits, it's a lot harder for markets to digest.
So how high can they go? I'm not going to pretend that I've got that crystal ball and give you any false precision here. Let's think in ranges, because the 10-year in the US is already in the mid-fours, the 30-year is around the 5% mark, there and thereabouts.
And those are important levels because they feed into mortgage rates, they feed into corporate borrowing, private equity, discount rates. I mean, we've seen what's been happening in that private credit space, for example, because this frames the hurdle rates of your investment, as you discussed on the discount factor.
So let's paint this in terms of scenarios. Because if the oil shock fades, then inflation expectations will settle down in the near term. And so then in that scenario, the 10-year probably doesn't need to run a lot further than it is right now. I mean, it's currently pricing in some of that US economy running hot.
And so you could see it stabilise in the 4.25% to 4.75% range, obviously with some volatility around the data. We've got to see what the incoming Fed Chair is going to do in terms of his direction on the markets.
But the other scenario is if oil stays high, then this conflict keeps that supply risk alive, inflation remains sticky. And in that scenario, you could see the 10-year test the 5% level, which is where the 30-year is currently sitting.
And I would say that's a lot more uncomfortable for equities when we start getting to those levels. I'd start to get quite concerned around valuations. Not just valuations, but companies raising credit, companies that have got to roll their debt. That all starts to become a factor, and they're going to have to do that at much higher yields.
The 30-year point, I referenced that, is also important because it tells us it's not just a Fed story, it's that fiscal story, it's a debt supply story. And so I would be comparatively more bearish on the longer end of the yield curve, certainly, because the market's going to need more compensation to lend to specifically the US government, but governments in general over longer periods of time.
If I break that down into two scenario paths, I would say your first is a sticky inflation path, the other is a growth-scare path. You've got to decide which path we're on. And I don't think that's quite clear. That's going to play out as we go down this road.
So it's not as simple as saying, hey, higher yields are bad, lower yields are good. The reason for the yields moving is actually what matters.
Now, to answer the second part of your question, which is a lot more difficult in terms of equity rotation, I'll try and keep this short. I'd like to almost shorten duration in the portfolio. You've got to be cautious on businesses where the story is exciting, but the cash flows are far away, because then you're buying this on the promise of future cash flows, and that goes out ad infinitum.
Certainly, if you look at some of the ratings that are out there on the stocks. And so when yields are low, markets are happy to capitalise those future dreams. When yields rise, you've got to ask a lot harder questions.
In terms of sectors, I would say the obvious one right now is energy. If yields are rising because oil is rising, energy is going to be a relative winner. There's lots of volatility around that. If the war gets resolved, you're going to see that sector come under a lot of pressure.
So I would say if you're in that sector at the moment, you're probably going to see a lot of people riding the momentum, but I wouldn't be looking at getting involved right now. I think a lot of that's been priced in.
Second bucket we could maybe look at would be financials. I think if you look at banks and insurers, they can benefit from higher rates, reinvestment yields. But the nuance here is that credit quality matters, because if higher yields start to create stress in the market, you see people defaulting on loans, properties, for example, if corporates struggle to raise debt at certain prices, financials are not immune. So a little bit more of a nuanced picture there.
The bucket I'd really like to focus on, there would be quality value. And this is not fashionable right now, right, but it's companies that have real cash flow today, decent multiples, pricing power. And this could be in any number of sectors. You could get them in industrials, which has been underperforming, incidentally. You can get them in infrastructure. Materials has been a good sector so far over the course of the last three quarters. And in a hot inflation environment, that's probably where you want to get some exposure.
So I would say those kinds of old-economy businesses that are not priced for perfection, that's where I'd be focusing.
Lastly, defensives here I would be more selective. You could look at healthcare and staples, they’re clean defensives. But if you look at things like utilities, they're a little more complicated, even property, because they tend to behave like bond proxies. They do carry a lot of debt.
And so that's how I would look at sectors, just at a very, very high level.
To wrap up, Ghost, the core message that I started off with is that bond yields are effectively the price of money. And so when the price of money moves, everything's going to reprice with that.
What we need to look at is why are those prices moving? What are your scenarios? And at the moment it's almost bifurcated because it's a combination of these factors, and so it depends on which of those scenario paths we actually start to walk down.
[00:16:37] The Finance Ghost: Near duration, cash flows, industrials — you have something to hang your hat on. There's assets on the balance sheet that's making cash now. It's not big promises that may or may not come to pass.
Thank you. I think that was a great run-through for our listeners. You'll notice that we have shortened the show each week to make it easier to listen to. We hope you're enjoying that. Give us some feedback, let us know what you want us to cover and what you are buying and selling. It's always very interesting to get feedback from our listeners.
And as always, go and check out Magic Markets Premium. That's where we do our detailed work on international stocks. We are covering Tencent this week, so that is very relevant to a South African audience. Companies like Prosus, Naspers obviously are really just proxies for Tencent at the moment, based on how the market is behaving.
So go and check that out. Mo, thanks. Avoid the potholes. We'll do another one of these next week.
[00:17:18] Mohammed Nalla: Thanks so much. Remember, hit us up on social media. It's magicmarkets, one word, Finance Ghost and Mohammed Nalla, all on X, or go and find us on LinkedIn. Pop us a note on there.
Until next week, same time, same place. Thanks and cheers.
[00:17:29] The Finance Ghost: Ciao. This podcast is for informational purposes only and is not financial or investment advice.
Please speak to your personal financial advisor.
