Explaining the Market Sell-off
There’s no doubt about the identity of the most important theme in the markets right now: rising US Treasury yields. It’s worth doing a crash course on bonds before we delve into the impact of rising yields on share portfolio values and the reasons for the recent sell-off in shares.
Bonds: price and yield move in opposite directions
Bonds are issued by governments or corporates as publicly traded debt. If you think about the bond on your house, it’s nothing more than a debt agreement with a lender (the bank) that has a specific term (e.g. 20 years) and an interest rate or yield (e.g. Prime +1%).
Let’s assume that the bank could sell your bond to other investors. Investors can take a view on your creditworthiness (perhaps based on a report from a credit rating agency like Moody’s) and value the bond based on the rate that you agreed with the bank.
Now let’s take it a step further and assume that the rate you agreed with the bank is 8%. If the general market rate moves to 7%, your bond is more valuable to investors because it pays a higher yield. But if the general market rate moves to 9%, your bond has gone down in value because it only pays 8%.
This is an illustration of the inverse relationship between bond prices and yields. If the yield goes up, the value of the bond goes down, and vice versa.
Are bonds good investments?
In his annual letter to Berkshire Hathaway shareholders, released at the end of February, Warren Buffett specifically highlighted bonds as a poor investment these days relative to a few decades ago. Yields are incredibly low, which has made bonds unattractive to investors as a source of income. He is talking about “investable” bonds like US Treasuries, rather than the “junk” you can buy right here in South Africa.
US Treasury yields have tripled recently, from around 0.5% to 1.5%. This causes chaos in the American bond market. As Cathie Wood of ARK Invest pointed out in a recent update video, there are record shorts in the bond market. This means that investors are expecting yields to keep rising (and the bond prices to keep dropping).
At some point though, the Fed will follow by increasing rates, although not until the US economy is out of the woods. If yields start to become a real problem for the markets, the Fed may intervene and buy bond yields lower. This means that a continued pullback in US bonds could be a buying opportunity.
In 2020, bonds in South Africa outperformed the general equities market. That helped some balanced funds (which hold a combination of bonds and equities) outperform pure equities funds. Our very own Retirement Fund benefitted from 25% exposure to various bonds. The local bond market is different to the US because our bonds are a high yielding emerging market “risk-on” asset whereas the US bonds are safe-haven or “risk-off” assets.
Predicting what 2021 could hold for the local bond market is difficult. On one hand, rising US yields are bad news for “risk-on” assets everywhere (like SA equities and bonds) as the world’s safe-haven asset class is paying better yields to investors. On the other hand, investors coming into our market in search of yield will give price support to our bonds.
Inflation expectations are driving the yield curve higher
The inflation issue is partly thanks to ongoing use of the printing press in the US. Another stimulus package has just been approved by the Democrats, which will see $1.9tn distributed to Americans in the form of a $1,400 cheque per eligible citizen. That’s in addition to the $1,200 a year or so ago and a further $600 payment that was made in December.
Much of this stimulus finds its way into the market, which is part of why we’ve seen such a strong bull market in the past year, but some of it finds its way into the real economy. Coupled with supply shortages in many products due to Covid disruptions, this heightened buying power drives an increase in inflation.
This is also part of why the Rand is strong currently. It’s less about us and more about a general weakening of the US Dollar.
As inflation picks up and concern increases about the level of debt the US is taking on, yields start to rise, especially on bonds with longer-dated maturities e.g. 10 years.
What does this mean for my share portfolio?
The tech sector has seen a significant draw-down in recent weeks. The Nasdaq 100 is down around 10% since the peaks in February. That doesn’t tell the full story though, with companies like Tesla down over 30%.
The reason is fairly simple: companies with higher growth expectations vs. current cash flows have been hit harder by the increase in yields. The yields on bonds are key drivers of the discount rates applied to cash flows. If you use a higher discount rate, the present value of the cash flows is lower.
So, a company like Microsoft which currently generates huge cash flows is far less affected than Tesla which relies on investors believing in the dream of autonomous driving and other high-risk, high-reward outcomes for Tesla that may be realised many years in the future. Those long-dated Tesla cash flows are now discounted at a higher rate since the yield curve steepened, severely impacting the present value.
If anything, these market disruptions point to the importance of an active investment approach. A correction after a strong run like we’ve seen in recent months is absolutely normal in the markets. The key is to know which stocks are worthy of “buying the dip” which is why we place client funds in the hands of professional management teams.