Dr. John Rutledge
Summary: Rising bond yields are the greatest investment risk investors face today. This week's earnings reports are likely to confirm that prices are rising faster than people think. Investors should focus on protecting capital from interest rate risk.
Bond Yields: Investors who wonder why stock prices have fallen by more than 2000 points since January in the face of strong growth and soaring earnings should ponder the chart below. The ten year bond yield poked its head above 3% this morning for the first time in 6 years. That's more than double its 1.39% level in June 2016, just 22 months ago. Rising interest rates are the greatest risk investors face today.
CBOE Interest Rate on 10 Year Note: TNX
As I wrote recently, there are many reasons to suspect that interest rates will keep rising from here. FOMC members are openly talking about strong growth and rising inflation. The Fed is selling bonds to execute its unwind-QE program. The PBOC has been selling Treasuries--even before the trade war mess--and other major central banks (ECB) will soon be net sellers too. The Treasury will issue $1 trillion of new debt per year over the next decade to finance budget deficits. This will almost double the national debt to $32 trillion in 2028, equal to its peak at the end of World War II of 105% of GDP.
Today I want to focus on a surprise investors are going to get when they examine this week's earnings reports that is likely to push yields higher.
Earnings Growth: One-third of the S&P 500 will report earnings this week. According to S&P, analysts expect Q1/18 earnings to grow at an 18.3% annual rate, as you can see in the chart below, rising to 21% in Q3/18 to average 18.5% for the full calendar year 2018. So far, 80% of companies have announced earnings exceeding analysts' estimates, even after increasing estimates by 12% after tax reform was enacted in late December. Earnings have beat analyst expectations by 5.9% so far in Q1/18 and by more than 3% over the previous year. There is a good chance realized Q1/18 earnings growth will exceed 20%.
But it is the growth of revenues, not earnings, that we should focus on. All 11 sectors in the S&P are expected to report positive revenue growth. Analysts expect 7.8% revenue growth in Q1/18, led by materials--think steel tariffs--at 21%. But so far, 70% of the companies that have reported Q1/18 revenue growth have beat expectations by an average margin of 1.6%. So a good guess for the final Q1/18 revenue growth number would be 7.8% + 1.6% = 9.4%. To be conservative, let's say there is a good chance the final realized number for revenue growth will be between 8-10% per year.
Here's where the surprise comes in. Revenue growth in Q1/18 of (8-10%) measures the growth rate of total output for the S&P 500 measured in current (nominal) dollars. But that is exactly what nominal GDP measures for the broader economy. There are reasons, of course, why we should be cautious in comparing the S&P 500 with the total economy--the S&P is only a subset of US companies; S&P companies are bigger and have more foreign exposure than average companies. But it will be interesting to see how close the S&P 500 revenue growth comes to the advance estimate of Q1/18 nominal GDP Growth that will be announced this Friday (4/27).
As a check, nominal GDP growth in Q4/17 was 5.3% while realized Revenue growth came in at 6.7% which is just above the 6.0% analyst estimate, so we might expect nominal GDP growth to come in 1-2% lower than the S&P revenue growth figure.
Why does this all matter? Because it gives us a way to piece together a rough guess of the Q1/18 inflation number that will fall out of this Friday's GDP release. Nominal GDP growth, of course, is just real GDP growth plus price growth. Q1/18 real GDP growth forecasts today range from the Federal Reserve Bank of Richmond's GDPNOW estimate of 2% to Deutsche Bank's 3%. To make an informed guess about the inflation number contained in the report we have to have a view of nominal GDP growth.
If the Commerce Department announces that in Q1/18 nominal GDP grew at a 8-10% annual rate, as discussed above, then they could also announce an inflation estimate of as high as 5-8% (the difference between the growth rates of nominal and real GDP). Even if I am wrong and nominal GDP growth comes in lower at, say, 6% the implied inflation number of 3-4% would still be a sharp increase from last quarter's 2.3% increase in the GDP price index and 2.7% increase in the PCE price index.
A positive surprise in nominal GDP, whether driven by surprises in inflation or real growth would push the Fed more aggressive in raising the Fed funds rate later this year. And it would nudge investor inflation expectations higher. Both imply further increases in bond yields. How high they will go is anybody's guess but it is useful to remember that the long-term average yield for the 10 year treasury is roughly double current levels. My guess is that we will se a 5% 10 year bond yield in the couple of years.
Investment Strategy: If you believe, as I do, that bond yields will rise considerably in the coming months and years there are a number of things an investor should think about. Most obviously, an investor should reduce exposure to falling bond prices. You can do this by replacing a portion of bonds with dividend-paying stocks, To the extent you own bonds, keep maturities low to avoid capital losses, even at the loss of current income. At current interest rates, a 10 year Treasury will lose almost 10% of its value when its yield rises by 100 basis points
If you own stocks, rebalance away from interest-sensitive sectors, like utilities, in favor of sectors where companies are more able to raise their prices. I would favor value stocks over growth stocks for the same reason I like short bond maturities--their shorter duration makes them less interest rate sensitive. And it means an investor should increase exposure to real assets, like real estate, relative to financial assets to take advantage of the change in relative prices that takes place when investors figure out that real assets provide inflation protection.
For a private equity and real estate investor like ourselves, the fact that interest rates are near their all-time lows and will rise substantially from here means that we have to be a careful buyer because less credit will be available and prices (multiples) are likely to be lower when we sell an asset some years hence than they are today. Lower multiples means we should expect lower returns on the base business and increases the importance of developing a thorough plan to improve and grow the business before we commit capital. We should be highly disciplined to only invest in sectors where we have the deep experience, knowledge, operating partners and professional networks to improve the value of a business and where we believe there is a macro storm system at work giving us an added advantage. We should be prepared to own businesses longer to fully execute our growth plans. We should prefer fixed-rate financing over floating-rate debt, longer over shorter term financing, and less rather than more in capital structures.
JR