In fixed income markets, quantitative easing meant a ready buyer of treasuries has been present, thereby suppressing volatility.
Central banks’ bond-buying actions have led to nominal rate volatility being considerably under-priced. Any reversal in trend via quantitative tightening will likely mean higher US Treasury volatility. Those looking for safety in the calm waters of bond markets could be disappointed.
Likewise, questions are being asked about the US dollar's haven status in the wake of the strong sanctions placed on Russia.
We do not think the USD will lose its reserve status any time soon, but we would not be surprised to see some reserve managers diversifying their holdings. Higher commodity prices are pressuring commodity importers and rewarding exporters. A new theme we expect to continue and mean some large currency moves lie ahead.
Within equity markets valuation multiples are traditionally anchored to the risk-free rate provided by sovereign bond yields such as the 10-year US Treasury or the German Bund.
As interest rates move close to zero or go negative, this valuation anchoring is removed, and emphasis shifts entirely to the attraction and excitement of the business model. In this scenario stocks can reach valuation ‘escape velocity’ where theoretically multiples can double, or more.
This effect caused the market to bifurcate violently between the winners of the low-growth low-inflation world (secular growth and technology) and short-duration, cyclical and financial losers over the past decade.
The effect of interest rates starting to rise has been dramatic in terms of rotations within equity markets – not because the secular growth business models have overnight become less attractive, but because valuation has emerged again as a risk factor as discount rates have risen.
The eternal debate
Our belief is that this is less about a simplistic baton pass from the growth factor to value, but more about the requirement for investors to place a much more granular focus on the valuation attached to individual assets, and to analyse corporates’ individual abilities to cope with the changing political, economic, and inflation environment.
The financial history of the past 30 years has been characterised by globalisation and the convergence of ideas and trade. This consensus is in a period of heightened challenge as the world becomes more divided, and we anticipate that remaining the case. The difficulties in trying to navigate the path of increasingly complex geopolitics means more variety in viewpoints and is likely to manifest in a greater spread of returns.