Source: Bloomberg and Saxo Group
So which type of companies are most sensitive to rising interest rates? Theory predicts that companies with low return on equity (or even negative), high growth rates, or high valuations have the highest equity duration. Our Bubble stocks equity theme basket is clearly the subset of equities we expect to have the highest sensitivity to interest rates, combined with private equity firms, real estate and high valuation IPOs. While equity markets are calm, growth investors should start now to balance their portfolios with defensive and low-duration equities such as commodities and high-quality companies with high return on equity and below-average equity valuations.
Exceptional US companies
While US equity valuations are high they are not high without reason. One factor is the low real yields, but that could also be said of Europe and here we do not observe the same equity valuations. Part of the explanation is that US companies have a significantly higher return on equity, currently at 17.1% compared to 11.3% in Europe, and as we have described in research notes, US companies on average have more stable earnings and grow faster due to their higher share of digital companies in public markets.
The high return on equity for US companies predicts that even with higher valuation levels today, US equities could outperform European equities. Let’s say that US and European companies deliver the current return on equity each year over the next five years: even if US equities today are 25% more expensive on price-to-book and revert to European equity valuation levels after five years, US equities would have generated 29% more return over that period. So it should be clear for investors that you need very good arguments for not still being overweight on US equities.
|Equity markets|| ROE (%)|
Inflation and the margin squeeze
The biggest risk to economies, financial markets and equities is inflation. It holds the key to upset the entire structure in place since 2008. Policies are being implemented globally as if we have a demand shock, but we are currently facing a supply side shock due to the pandemic, lack of investments in the physical world, and an accelerated decarbonisation through electrification and renewable energy. These forces are putting enormous pressure on commodity prices and our view is that the green transformation combined with the current policy trajectory will sow the seeds of a commodity super-cycle that will last for a decade.
In addition policies in the developed world and China will increasingly address inequality to avoid social unrest, which will mean higher taxes on corporates and capital, supporting higher wage growth for low-income individuals. The combined effect could cause inflation to run higher for longer and above the 2.3% average in the US since late 1991. One conundrum is that since the world has become very sensitive to interest rates, what will central banks do if inflation remains above average for a long time? Either they raise rates and cause pain to our indebted economy, or they stay put and let real yields go even more negative. Could equities enter an outright melt up scenario under these conditions? It is not unthinkable.