The tail wagging the dog?

US political strategist James Carville once remarked, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. Now I would like to come back as the bond market. You can intimidate everybody!" This witticism was vividly bought to life in February.

The ongoing progress made in administering vaccines more widely has raised the prospect of considerable levels of pent-up demand being unleashed as the global economy re-opens in the second half of 2021. Combined with ample amounts of monetary and fiscal stimulus – and assurances by governments and major central banks that policy will remain accommodative for several years – the outlook for an increasingly robust economic recovery over the next 18 months is taking shape. Alongside the prospect of this stronger economic recovery is the fear that permanently higher levels of inflation –benign for a long period of time – could be unleashed.

In our February investor webinar, we specifically addressed the issue of inflationary risks in some detail. We anticipated the potential for an inflation-led market wobble during the first half of 2021 as reported year-on-year inflation cycles the disinflationary period of March to July 2020. The volatility experienced in February may be the first sign markets are beginning to price in the implications of potentially higher levels of inflation.

Should inflation run hotter than the Federal Reserve is comfortable with – meaningfully above 3% year-over-year for a sustained period of time – the risk of interest rates needing to be increased to cool down the economy would be materially higher than markets assume today.

To illustrate why higher bond yields could negatively impact valuation, imagine that you invest in an asset that will produce $1 in cash flow in year one, growing thereafter at 3% every year into perpetuity. How much should you pay for this asset? The answer depends to a significant degree on your discount rate, which is determined by the prevailing interest rate offered on long-dated government bonds.

In the chart below – adapted from our aforementioned webinar – we illustrate that as the discount rate rises, the fair value (or justified price) of a stock declines. Higher interest rates, all else equal, leads to lower valuations.

At present, our central case is that inflation will increase in 2021, but will then trend back down towards 2% over time. However, despite the fact that we believe there is a high likelihood of an inflation overshoot this year, it is an open question whether the current market positioning and structure is sufficiently robust to absorb rates moving sharply higher. On the evidence offered in February, there are potentially quite a few pockets of the market where higher discount rates will have a materially negative impact on valuations – in particular for highly leveraged investors. We remain cognizant of these risks and over the last few months have taken steps to reduce some of our exposure to long-duration cashflows.

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Aitken Investment Management is an independent global fund manager that aims to capture long-term secular trends by investing in high-quality businesses that can compound in value.

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