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For the last 12 months, I have been warning about the capital loss risks in government bonds and “defensive” equities, as interest rates rise from historic lows. I am of the view that interest rates, inflation, and volatility have bottomed, while conversely, we believe the price paid for long duration bond sensitive “defensive” equities has peaked.
Last week, 10yr US Treasury Bonds rose in yield to a 7-year high of 3.12%, and US 30-year Treasuries rose to a 3-year high yield of 3.25%.
I believe this is the start of bond yields moving into a new higher trading range and it has widespread ramifications from portfolio construction and stock selection globally, through to variable mortgage interest rates in Australia. This is a global event as the cost of money rises and the risk-free rate rises. It affects everything directly and indirectly.
My AIM Global High Conviction Fund, due to its broad long/short global mandate, is physically short US 30-Year Treasury Bonds and a number of individual “defensive” stocks in the utility, healthcare, infrastructure and supermarket sectors we feel have significant share price downside as bond yields rise. Those positions have been profitable for the fund this month, as the world starts to realise there are no “defensive” pricing characteristics in bonds and bond-like equities. Capital loss risk far outweighs the small coupon they offer.
For example, if we are right and the US 30-year Treasury yield rises from 3.20% to 4.20%, the capital loss on that bond will be around -23% due to its long-duration (the longer the duration, the more sensitive the bond price is to interest rates).
The chart below shows the US 30-year Treasury yield has broken major multi-year technical support at 3.20%. We are targeting 4.20% as the medium-term target for the US 30-year yield.
In our strategy, we have consistently pointed to the second half of 2018 as being the time when the central bank bid disappears from the bond market, and the supply of bonds increases, led by the now less fiscally disciplined USA. We expect a significant increase in bond supply as the US deficit increases from 2% of GDP in 2015 to over 5% of GDP in 2019.
A step up in fiscal stimulus at a time of full employment is also a majorly inflationary cocktail.
Inflation readings will be cycling weak pcp’s, which will lead to high year-on-year CPI and PPI data in the second half of 2018. We are forecasting US CPI above 3% in the second half of 2018 and well above the Fed’s target range.
Fundamentally, we believe the true trigger or catalyst for the bond sell off will be rising wage inflation, led by the USA. With US unemployment at 3.9%, effectively full employment, there is only one way US wages can go: UP.
The chart below shows US wage growth turning up and the Fed Funds Rate following. The 2nd chart shows 3 month/ 3 month US Core PCE Inflation is already at 2.5%
It could well be the perfect storm for bonds in the second half of 2018, and we believe it’s prudent to be short bonds and bond proxies ahead of this.
An example of a “defensive” stock we are cautious on is ASX-listed Sydney Airport (SYD). We believe Sydney Airport is significantly overvalued and vulnerable to a significant de-rating, as long bond yields rise globally.
Below is a simple overlay price chart of Sydney Airport and US Treasury Long Bond Futures (US1). As yields rise, the capital price of the futures fall. You can see from 2013 to mid-2017 that there was a very close performance correlation between Sydney Airport and US1. We feel the outperformance of Sydney Airport versus US1 is unlikely to persist, and if we are right, and the two instruments re-correlate, then Sydney Airport’s share price would be closer to $5.50, -21% below its current share price. It’s worth noting Sydney Airport is already an expensive stock, trading on 39 times earnings and EV/EBITDA multiple of 18.5 times, yet only growing EPS at 7% in 2018.
Recent data shows all-important international passenger growth slowing for Sydney Airport, but particularly passenger growth from China. International passenger growth for April was 1.8% and year-to-date 5.1%. Analysts’ forecasts are around 6% for 2018, so there is downgrade risk in Sydney Airport if international passenger growth doesn’t reaccelerate. Risks appear to be more skewed to the downside, driven by slowing Chinese passenger growth rates. Chinese passengers grew by 4.0% year-to-date, compared to a 17.3% compound average growth rate over the last four years. This also impacts retail revenues, given duty-free spending by Chinese passengers is around three to four times the average retail spend.
Australian outbound is also reverting to normalised growth levels, increasing 3.6% year-to-date versus a growth rate of 5.6% in 2017 and 6.5% in 2015. It would seem clear that residential property prices consolidating have somewhat slowed the “wealth effect” and we are now seeing Australian outbound passenger numbers slow.
The gross yield of 4.96% has supported the stock but will become less attractive as bond yields rise. To our way of thinking, Sydney Airport is a classic ‘defensive’ asset that is currently not priced “defensively”. Interestingly, the stock just broke down through its 200-day moving average, which indicates short-term momentum is also turning negative.
I realise I have been warning on the risks in the bond markets and defensive equities for some time, but it is starting to happen. In fact, it’s starting to happen right as we face the second half of 2018 where the fundamentals of supply and demand change for the bond market.
This is a major development in the investment cycle and requires attention in your portfolio.
Many of you would realise buying a stock or bond simply for the attraction of its current dividend yield can lead to substantial capital losses. A classic recent example would be Telstra in Australia. The Telstra example is telling you to be careful in most yield-only based investments.
That is one reason today I am telling you to be careful in Sydney Airport: the 4.95% unfranked yield is not worth chasing ahead of a potential 20% capital loss if I am right, and long bond yields continue to rise globally. It’s also not the time to own expensive low growth assets on very high P/E’s. That is also a potentially capital destructive plan.
There are plenty of stocks I like and own on the ASX, but I do think there are clear grounds to be cautious on ‘defensive’ stocks and sectors that do not currently have defensive valuation characteristics.