US rate rises are not a done deal (Archived)
By Esther Armstrong, BNY Mellon IM EMEA
Contrary to consensus expectations, US interest rates may remain “lower for longer”, perhaps even until 2020, according to James Lydotes, portfolio manager at The Boston Company Asset Management.1
Lydotes, who heads the Global Infrastructure Dividend Focus Equity strategy and covers the non-US healthcare, utilities and technology sectors, cites four main factors that support his thesis: modest inflation expectations, weak global growth, an accommodative European Central Bank, and a demographic shift driven by the ageing baby boomers.
He does not see these dynamics changing any time soon. “Yet,” he adds, “There’s consensus across the equity markets that rates are going higher and will pull up banks’ valuations while destroying the valuation of utility companies and bond proxies.”
At the start of 2014, two-thirds of active US large-cap equity managers were positioned for rising interest rates, resulting in a close alpha correlation between their portfolios and interest rates.2 Around half were very closely correlated.
But, Lydotes observes, rates didn’t follow the course that these managers expected. Instead, “rates went down, taking with them the performance of those active equity managers who were resting on that view”.
While rates are widely viewed as having bottomed, he does not believe their imminent rise is a foregone conclusion. He notes the US market has sustained a catastrophic market correction following a real estate bubble; increasing net federal debt as a percentage of GDP; and a zero interest rate policy implemented to stimulate growth, which failed to work when banks did not lend.
“Add to that the once-in-a-generation issues faced with an aging baby boomer population, and it starts to seem possible the next move in rates is not up — but down,” says Lydotes.
There is not much indication of stronger growth elsewhere across the world either.
China, which has fuelled global growth for the past 20 years, has been very open about moderating that growth and switching to a consumption-based economy. Meanwhile, Brazil does not look likely to replicate the performance it contributed in the past, and Russia is increasingly following an isolationist policy.
“India is probably the one bright spot,” says Lydotes, “But it is highly unlikely that India can offset subdued growth from the rest of the world.”
Meanwhile, the bulls’ favourite arguments for the return of ‘normal’ growth rates start to fall apart upon closer inspection.
The first of these centres on the replacement cycle, namely that technology and medical equipment as well as office furniture and fixtures are vastly older than their 30-year average and will need to be replaced soon.
“The real trouble is we have been waiting for this to materialise for the past few years, and we have not seen it. This equipment does not self-destruct when it reaches a certain age,” he says. At the headline level, healthcare equipment that is 8% older than its 30-year average seems like a convincing statistic, but in fact, that only equates to four months.3
Meanwhile, another panacea trotted out by growth enthusiasts is the record levels of cash on companies’ balance sheets. In the US, companies are hoarding more than US$3.5 trillion in cash, far above the levels seen before the global financial crisis.4
At the same time, however, they have taken on more debt, so US$3.5 trillion only represents 40% of corporate debt levels. Back in 2005, the US$2 trillion of cash held was the equivalent of 55% of total company debt.5
“Companies are hoarding cash, but at the same time, they’re borrowing at record levels, so their urgency to spend that cash is greatly reduced,” Lydotes points out.
In addition, capex is no longer subdued, he says, and in fact has already closed the gap and surpassed levels experienced before the global financial crisis.6
Rising inflation, which would be a prompt for the Federal Reserve to hike interest rates, is not expected to come into play either, with little sign of wage or commodity inflation to drive it higher, says Lydotes.
He will be keeping an eye on both of those metrics as well as looking for any rhetoric reversal from the European Central Bank. Any surprises in global growth could also lead Lydotes to revisit his thesis.
In the meantime, income orientated asset classes in the form of high quality US equities, global natural resources and infrastructure could offer opportunities.
“You want to focus on yield growth rather than absolute yield levels, as it’s more predictive of growing income streams in a business,” he concludes.
1. Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited ("BNYMIM EMEA") or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.
2. Factset, Correlation as of 1/1/2014
3. US Department of Commerce, Bureau of Economic Analysis 31/12/13
4. Factset 31/12/13
5. Deutsche Bank Global Markets Research, FRB, Haver Analytics as at 31/12/13
6. Bloomberg 31/3/14