Monday, July 15th, 2013

Three Short Notes

This week is devoted to following up some ideas we have already written about in recent weeks: the correlation of US equity and bond returns, the importance of duration in the equity market as well as the bond market, the future of US real estate finance.

Equity markets are happy. The Fed has made it clear (again) that any move towards tapering QE is data dependent. This allowed US equities to rally by 3% last week and most other markets round the world followed suit. Treasury yields also fell across the curve. Equities up; bonds up; what could be wrong with that? Nothing: except that it is entirely consistent with our view that the two asset classes are moving towards a period of positive correlation. This means that there will come a time when they both go down together. This is not an immediate threat, but an asset allocation process which does not allow for this sort of regime change will be severely compromised sooner or later.

Duration matters. This is something all fixed income investors understand and track on daily basis. For equity investors duration is a much more nebulous concept. The nearest equivalent is the PEG ratio – the PE ratio divided by long term earnings growth – but problems with data definitions and negative or unstable growth rates mean that it is not widely used. All too often the duration question gets side-tracked into a debate about earnings quality and product life-cycles.

And yet duration matters for equities as well. No-one disputes that most large-cap Consumer Staples have excellent earnings quality and reasonable long -term growth rates, especially if they have an emerging market exposure. These two factors give them excellent defensive characteristics, but only if bond yields are stable or falling. If bond yields are rising, their high PE ratios (low earnings yield) make them anything but defensive. Investors who are selling 10- year Treasuries and buying 2-years, should also be rotating out of high PE and into low PE stocks.

Last week also saw the introduction in the US Senate of a bi-partisan bill to reform the U.S. housing finance market, which would replace Fannie Mae and Freddie Mac with a new independent government agency. This agency would operate a Mortgage Insurance Fund charged with providing a limited government-backed guarantee of qualifying privately issued residential mortgage-backed securitizations (“RMBS”).

This has the potential to be a game-changer in the field of US real estate finance, yet there is one issue which no amount of legislation can address. Will investor demand for RMBS hold up in a period of rising bond yields? Our own view is that investors will come to prefer a securitised rental stream, rather a stream of mortgage payments. Rental growth (even if it comes with the risk of vacancies) has the capacity to alter the duration profile of the cashflows from housing and should offer the investor greater capital protection.

Three apparently unrelated ideas, and yet there is a common thread. All deal with the way in which investors will change their behaviour and their assumptions as they adapt to the end of the great Treasury bull market.

2 comments on “Three Short Notes

  1. Simon on said:

    Call it a rate normalization process, if you prefer, but the rise in yields is going to make the long end of the curve produce results which are consistent with a bear market. Your view that yields will be capped at 4-6% assumes that the Fed keeps control of inflation – which is reasonable for now, but has to be kept under review.

  2. Steven Vandepitte on said:

    Isn’t the end of the Treasury bull market more like a rate normalization process, i.e. the re-introduction of term premia in the curve after the excesses of consecutive QE? An ever increasing number of retiring baby boomers look like ‘captive clients’ for income generating Treasuries at anything between 4 and 6%… putting a cap on yields.

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