What is the impact of interest rate moves on different types of global companies and the notion of short and long duration stocks?
Reflation
In the last quarter of 2021, inflation was definitely the topic du jour; however, inflation is only one third of the reflation story. Reflation is important, because it will likely result from interest rates moving upward and as illustrated in figure one, rates have hit an inflection point.
There are three key factors that will feed into reflation:
- Above trend economic growth around the developed world, which is likely to persist for at least the next couple of years.
- Inflation, in particular that it is less transitory than was initially suggested. Figure one shows year over year change to the US consumer price index and illustrates an evident trend.
- In response to both of these phenomena – the above trend economic growth and the inflationary pressures building in the system – central banks are setting the stage for rate normalisation.
Following the most recent meeting of the US Federal Reserve (14 December 2021), a dot plot was provided to the market (figure two). The median line is the midpoint of the forecast from each of the individual members of the Federal Open Market Committee; professional investors tend to focus on this median line to see the general trend. Figure two provides both the September and December dot plots and clearly shows that the people who set monetary policy in the United States are expecting to raise interest rates for the next few years.
During the 14 December meeting, the Fed signalled its concern about inflation and stated that as a result, it is accelerating the pace of asset purchases. Importantly, the Fed indicated it was likely to raise rates three times in 2022, and then three times in 2023.
Higher rates seem very likely from here – what does that mean for stocks?
Duration
While duration is more commonly discussed in relation to bonds, the concept of duration can offer valuable insights for stocks. Like bonds, stocks vary in their sensitivity to interest rates and this sensitivity depends on the timing and amount of future earnings and future cash flows.
Growth stocks turn to be longer in equity duration; they have cash flows and earnings out in the more distant future; therefore, those cash flows will be more sensitive to changes in the discount rate that’s used to value those cash flows from the future.
On the other hand, consider those stocks that have substantial ‘here and now’ cash flows, are receiving earnings and cash flows this year and next year and are generally paying dividends. These tend to be the short duration stocks and should be less affected as interest rates move higher.
As bond investors know, when rates are headed up the smart move is to shorten duration. Similarly, equity investors should be thinking about the risk in their portfolios from holding long duration equities in a rising interest rate environment.
Figure three comes from a recent study published by the Journal of Accounting & Research. The authors use the concept of equity duration to analyse the pandemic drawdown, which occurred in March 2020. The finding was that the pandemic drawdown hit short duration equities harder than long duration equities.
When the pandemic hit, it hit hard and it hit fast, but it was expected to be a relatively short term phenomena. As a result it was the short duration equities, those companies whose immediate earnings and cash flows would be hit the most, which experienced the bigger drawdown in this episode.
Figure three spans from January 2020 to the end of March of 2020 and shows the cumulative excess return. The bottom line represents short duration equities, and the top line shows long duration equities. It is evident that it was the short duration equities that took the hit in the pandemic when the drawdown occurred.
Another insight for recent stock behaviour using duration is provided in figure four. On the left is 25 years of MSCI World Index history. Over this long term period, the highest average annual returns occur for companies with growing dividends, followed by companies with stable dividends, followed by companies with zero dividends, and lastly, followed by companies that are dividend cutters.
On the right hand side is the most recent 22 months, from January of 2020 through to the end of October 2021. During this period, the highest return was for companies with zero dividends. Now this anomaly is puzzling until you consider duration. In fact, this chart on the right is simply the flip side of figure three; long duration equities had a strong run during the pandemic and that’s what is apparent here.
What about going forward if interest rates are indeed headed higher? Long duration stocks are likely to face stronger headwinds. The present value of any asset is found by looking at the cash flows generated by that asset overtime and discounting those cash flows back to the present using an appropriate discount rate.
This calculation tells us that for a given increase in interest rates, those long distant future cash flows will be affected the most. However, given the likely above trend growth environment for the next couple of years, it is possible that such growth can mitigate and offset some of the effects of higher interest rates.
Some commentators suggest that dividend paying stocks suffer as rates rise; consequently some investors think about shifting to fixed income. However, that has not been the case historically (figure five). The chart shows that dividend payers tend to do well relative to other stocks in a rising interest rate environment, which aligns with Epoch’s view about how dividend paying stocks behave when interest rates go up.
However, long term rates are more important in terms of the discount rate used to value stocks. As shown in figure six, in the first quarter of 2021 the 10 year treasury yield jumped about 60 basis points. The circled area highlights a period when a sharp rise in rates caused an adjustment in the PE ratio for the broad index. However, this uptick in rates had a much more muted impact on either the high dividend yield index or the global equity shareholder yield strategy.
Both the high dividend yield index and the global equity shareholder yield strategy focus on companies that pay dividends currently. Holdings can be characterised as short duration stocks, and Epoch believes this explains the smaller impact on the PE multiple for both when compared to the MSCI World Index.
From another perspective, figure seven moves away from theory and provides a real life example. The left hand side shows the broad global equity universe in the first quarter of 2021. When long term treasury yields jumped, the more yield you had your portfolio – and therefore the shorter the duration – the better off you were.
The global equity shareholder yield strategy, the brown dot in this chart, had more yield than most portfolios, which was a big positive factor. In the second quarter (right hand side), treasury yields drifted back down and this dynamic reversed; yield was a big negative factor in the second quarter relative to other strategies, even though absolute returns were still strong.
Salvation
It is Epoch’s belief that shareholder distributions will be the more reliable, perhaps even the most significant component of equity market returns in coming years. As such, global equity investors are less likely to experience returns coming from expanding multiples moving forward.
If anything, the impact from changes in multiples could reverse as rates normalise. Some investment professionals believe that dividends will be the dominant form of total returns in the coming decade, as price returns could face pressures in the absence of expanding multiples.
As the Bank of America data shows in figure eight, right hand side, dividends have historically represented 37 percent of total returns. Bank of America suggests that dividends could in fact represent a larger portion of total returns in the next 10 years, as price returns face headwinds as shown in its outlook on the left hand side.
While Epoch does not believe dividends will be investors’ sole source of equity market return, it does believe dividends will continue to be important and will represent a larger portion of equity market returns in coming years.
Figure nine presents a framework for thinking about the long term history of the components of equity market returns. These market returns can be broken into dividends, earnings growth – which is a proxy for free cash flow growth, and changes in multiples.
Dividends, the orange bars, are always positive contributors to returns. Earnings growth, represented by the light blue bars, is almost always a positive contributor to returns over rolling 10 year periods. The big swing factor is the change in multiples which, over the long run, is not a meaningful contributor to the equity market returns.
As such, dividends and earnings growth are the more stable drivers of equity market returns and are the elements central to a shareholder yield strategy, which focuses on companies with capital allocation policies that emphasise stable and growing dividends, supported by consistent and predictable cash flow growth. Cash flow growth supports further reinvestment for future growth, but it also adds to the stability of the cash distributions back to shareholders. As the company grows so does the cash distribution back to shareholders if the company has a consistent capital distribution policy.
Clearly illustrated in figure nine is the fact that dividends have not only been positive and reliable, but they have been a significant source of return over time. As price returns move up and down, a dividend oriented portfolio always starts with a positive total return buffer.
When one considers dividends more holistically, there are three ways a company can return cash to shareholders – dividends, share buybacks and debt paydown. All three are dividends of sorts in that they provide the means for a company to return cash to shareholders.
The Covid pandemic has not altered sound capital allocation policies. If a company can earn above the cost of capital, it should reinvest in the business or make acquisitions, for these are the fastest ways to create value. However, there’s not an unlimited supply of opportunities for companies to earn above the cost of capital.
Higher rates will present a valuation headwind for long duration equities, especially for long duration equities that already have stretched valuations. In these stocks, rates present a risk. We think investors need to acknowledge that risk. In such an environment, investors can look to companies that return cash to shareholders through dividends and share buybacks. Given that many companies across a variety of sectors are moving towards more ‘capital light’ business models, replacing both capital and labour with technology, the opportunity to reap the benefit from dividends and share buybacks is likely to continue to grow.
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