Good morning. Yesterday, long bond prices stopped falling, and everyone exhaled. Kate Duguid, our fearless colleague from the bond desk, will survey the fixed-income wreckage in Unhedged on Monday, while Ethan and I are away. In the meantime, email me: firstname.lastname@example.org.
Rate shocks and growth stocks
I’ve argued at some length recently that there is not a simple mathematical relationship between moves in rates and the relative performance of growth stocks. Why, then, is it that at certain moments, rates move up and then growth stocks slump with Pavlovian responsiveness? The view that this co-ordination is simply down to the long duration of growth stocks is demonstrably wrong. But there is something here that needs explaining.
Sven Ebert and Pablo Duarte, of the Flossbach von Storch Research Institute, tried to explain it in a paper published earlier this year. They argue that sharp changes in both inflation expectations and short rates have historically been followed by underperformance by information technology (that is, growth) stocks. So it is not the level of rates and inflation — and therefore the discount rate used to value future cash flows — that matters. It is the speed and direction of their changes.
Ebert and Duarte use a multi-factor statistical model to track the impact on the US stock market of five variables — break-even inflation expectations, forward interest rates, the yield curve, credit spreads, and the three-month Treasury rate — and the interactions of these variables.
They find that a shock increase in inflation expectations, and the associated upward shock in short rates, has a pronounced negative effect on the whole market over the next year and a half (holding the influence of the other variables constant). No surprise there: it is a Wall Street truism that stocks don’t like inflation (even if bonds like it less). What is more interesting is that IT underperforms the market as a whole after such shocks, while energy outperforms and consumer staples shrugs its shoulders. Here is their chart of the sector response after a positive shock from break-even inflation (which brings higher rates in its train):
Ebert and Duarte point out their statistical model fits with visible patterns in the long-term data. Looking at IT sector returns, you can see irregular but suggestive correlations between break-even inflation shocks and low or negative returns over the next five quarters:
It is important to note that study is based on a data set that goes back to roughly the turn of the century and up through 2022. Until the very end of that period, we were in a falling rates regime. It could be that if we are in a new inflation and rates regime in the next 20 years, the relationships they map may not hold up.
More important, perhaps, is how to explain the relationships that the paper teases out. We cannot simply refer to higher discount rates on future cash flows, because the historical data shows that relationship between valuations and rates is all over the place. When I put this to Ebert, he said it may be that sharp changes in inflation expectations and rates may make discount rates and stock valuations very vivid in the mind of market participants. Growth valuations become an important market narrative.
If that’s right, shouldn’t there be a trade in there somewhere? It appears that growth stocks fall in response to inflation and rate shocks in a way that may not reflect changes in fundamental value. Possibly. But maybe growth stocks’ sensitivity to these shocks partly reflects the fact that those stocks became overvalued in the low-rates era, and the market knows it.
Two weeks ago I wrote about copper, pointing out that everyone agrees that there appears to be a lot more demand for than supply of the stuff in the medium-long term (5-10 years from now, say). The green transition needs a lot of copper, but there are not a lot of new mines being dug and old mines are becoming less productive. I concluded that the shortage looks real, but I am worried about the elasticity of supply, about whether the green transition will really happen, and about the fact that structurally commodities are just bad investments.
I was therefore interested to read an investor note Bridgewater published earlier this week, arguing the metals cycle driven by the green transition will not be like other cycles. The reason is that the green transition is a demand shock that everyone sees coming from a mile away. As a result, governments and companies are providing supply incentives, exploring substitutes, and investing in technology to reduce demand. So the price picture is not as bullish as it may seem for nickel, lithium, and cobalt.
But copper is something an exception: “Copper has not yet seen the investment or supply growth needed to meet energy transition demand. Looking forward, it’s less clear that supply will be able to keep pace . . . structural shortages are possible around 2030 if companies don’t undergo greenfield investments.” Furthermore, copper presents the fewest opportunities to use technology to lower demand or increase supply.
This reminded me of a line that Saad Rahim of Trafigura told me he uses when talking to government and corporate officials: “You need to worry less about the rare earths and more about the boring earths.” Still, Bridgewater doesn’t think sustained high prices are inevitable — just that to avoid them, new mines need to be dug, starting roughly now.
Marcus Garvey, who runs the commodities strategy team at Macquarie, thinks this demand shortage will follow the pattern of previous ones: the market will find a workable supply-demand balance, but only after a significant price spike creates an incentive. “Who knows what the equilibrium price that will resolve this deficit is,” he says, “But we don’t just arrive at equilibrium. At some point you will overshoot it.”
It’s not just new mines that a price spike would incentivise. He argues it is plausible that the amount of copper needed for an electric car could fall quite a lot — from nearly 80kg now to perhaps somewhere in the 40s — if the pressure was really on the auto industry to make it happen.
Still, even with the possibility of a big move up in price three to five years in the future, investing in copper is not like owning a stock, he says. The history of commodities shows you can’t just buy and hold: returns on the big commodities indices have simply not been that good. That leaves investors in search of diversifying exposure to commodities with the complexities of the options markets. More on that from Unhedged in the coming weeks.
One good read
Here’s a hard job.
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