The ten-year U.S. Treasury bond rate is the most important parameter in investing, used by investors of all types to establish relative return metrics. Ten years encompasses about two regular business cycles and is a practical time-frame for investors to work with: it avoids both counterproductive “shortermism” as well as the unfathomable long term. Therefore, investors estimate cash flows ten years in advance and discount these by the risk-free treasury rate added to a premium which measures the specific risk of the investment.
So, what happens when 10-year rates approach zero or even negative rates, as they now have across Europe and Japan? U.S. rates, currently around 0.60%, are at historical lows in nominal terms and well into negative territory in real (inflation adjusted) terms, as shown in the graph below.
What do these historically low interest rates tell us? In the past, the nominal ten-year rate has been a relatively good predictor of nominal GDP growth. This relationship has been reliable over the 1970-2020 period when both nominal GDP and the 10-year Treasury rate have averaged a little over 6% per year. The current low rates, then, may point to a combination of deflation and low GDP growth in coming years, unless an argument can be made that rates are being artificially repressed by the Fed (and elsewhere).
If valuations for stocks are determined by discount rates linked to the 10-year rate, what are the investment implications of the current circumstances? On the one hand, very low rates imply high valuations, as long-term cash flows increase in value as discount rates decline; on the other hand, tepid economic growth pushes down valuations, as cash flows for most company are closely linked to economic output. In summary, what the investor gains from low valuations he losses from low cash flow growth.
The current state of the global economy is depressive with low growth prospects. Most countries face poor demographics and excess debt. Concurrently, most industries are being brutally disrupted by an eruption of practical innovations spawned by the “information and communications” revolution. In this environment of low growth and disruption, one would expect that, in general, corporate profit growth would be weak, but that those few companies enjoying growth and benefiting from disruption would be rewarded with high valuations. The current Covid-19 environment has starkly heightened these trends, as most companies have been devastated by the crisis while for a few disruptors it has been a boon.
Of course, most of these winning companies are U.S. based, and that explains the high valuations for tech companies in Silicon Valley and other frontier industries. These companies either have predictable long-term growth (eg. Amazon, Microsoft) or exceptional market opportunities (eg., biotech). These sectors benefit from long-duration cash flows which discounted at today’s low rates result in very high values. When found outside the U.S. — tech in China, Korea and Taiwan, e.commerce in Latin America (Mercado Libre) or South-East (SEA) — these firms are also highly valued.
In both the U.S. and international markets, “growth” stocks have performed much better than “value” stocks over the past decade. This is because growth has been scarce and low discount rates have boosted the value of long-duration cash flows. The problem for international and emerging markets is that “growthier” sectors (information technology, fintech, e.commerce and bio-pharma) have much less weight than they do in the tech-heavy U.S. stock indexes. This is particularly true in emerging markets where financials, industrials and commodities dominate the indexes. To make matters worse for emerging markets, at the beginning of this period of low growth and great disruption, around 2010-2012, these sectors had extremely high valuations.
Take the case of financials. In the past in emerging markets highly profitable banks with dominant market positions were favorites of investors. 10 years ago, financials in EM represented 24% of the index, led by the Chinese and Brazilian banks. Today, financials in EM represent only 18.5 of the MSCI index and they are suffering from a combination of low growth, historically low interest rates and attacks from tech-enabled disruptors which are often abetted by regulators. Technology only represents 16.5% of the EM index (most of which is in China) compared to about 45% of the S&P 500, while financials have fallen to only 10% of the U.S. index.
So, what could change the current paradigm of the market and make emerging markets attractive again?
Well, obviously a rise in inflation and interest rates would be beneficial, since this would reverse the cause of high valuations for growth stocks. A spike in the ten-year treasury rate would have a large impact on the valuation of companies with long-duration cash flows and cause a major shift in valuations, allowing “value” stocks to outperform in relative terms. However, this does not appear to be imminent. On the contrary, rates continue to be on a strong downtrend.
Nevertheless, we may be seeing some “green shoots” of a reflation trade. These can be listed as follows:
- High valuations for growth stocks are causing a rotation into underperforming segments of the market, including emerging markets.
- China stimulus is pushing up commodity prices. Industrial commodities, led by copper and iron ore, have rebounded strongly.
- Potential inflationary shifts in U.S. public policy: forced reshoring of manufacturing, boosts in minimum wages and union influence, universal income and expansive monetary and fiscal policy.
- A weakening dollar and concurrent rise in alternative currencies (gold, bitcoin).
The USD has weakened significantly from the March high, and an extension of this trend would be important evidence supporting a regime change towards higher inflation