How sensitive is your portfolio to interest rates?

How sensitive is your portfolio to interest rates?

Equities 10 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  Growth stocks have got an awful start to the year as a function of the US 10-year yield rising to the highest level in a year showing how growth stocks are more sensitive to higher interest rates. We go through why interest rate sensitivity matter for investors and how to reduce the equity duration risk. We are also discussing the recent steep selloff in Sea Ltd which was extended yesterday on the news that Tencent had reduced its stake by $3bn.


US interest rates rise is crushing growth stocks

This year the Nasdaq 100 is down 4% while the US 10-year yield is up 22 basis points and got more tailwind last night from the FOMC Minutes showing that the Fed is a bit more nervous about inflation compared to the press release in December. If one squares the opposite moves you get to an equity duration (interest rate sensitivity) of around 18 for the Nasdaq 100 and around 50 for our bubble stocks basket, which we wrote about in yesterday’s equity note. Now that assumes that the entire move is driven by interest rates moving higher and that is clearly not the case in a highly dimensional complex system.

Source: Saxo Group
Source: Bloomberg

Last year we spoke several times of interest rate sensitivity starting as the Nasdaq 100 wobbled during the rise in interest rates in the beginning of 2021 and again in November when the theme came back to haunt growth stocks. It can be shown that the further out you have to forecast free cash flows to get back to the current equity valuation of a company, the higher the equity duration is. What is the equity duration actually why is it important for your equity portfolio?

Equity duration and why it matters

Equity duration is the estimated impact from 100 basis points move in the relevant 10-year yield (depends on which currency cash flows are measured in) holding all other variables constant. I have recently estimated Adobe’s equity duration to around 25 based on a discounted cash flow model which is lower than the estimated 42 based on this week’s observations. This underscores our point that more is going on than just a move in interest rates. As we highlighted yesterday a more sticky inflation outlook could be driven portfolio changes hitting growth stocks as investors add other types of component to their portfolios.

The reason why it is important to understand the concept of equity duration and try to measure it is that gives you an idea of your interest rate risk. The reason it impacts equities is that a stock is a claim on a cash generating asset and thus is priced based on discounted future cash flows and the risk-free interest rate goes directly into the discount rate. Higher interest rate means higher discount rate and lower equity valuation, or else being equal. Many speculative growth stocks have a high equity duration, but companies with a high degree of debt financing relative to equity value also exhibit high equity duration.

Many retail investors have arguably too high exposure to speculative growth equities and thus they have high interest rate exposure without knowing it. As we have said for a year now, it is wise to begin balancing the portfolio blending growth with more low equity duration assets and especially those with supposedly inflation hedging capabilities. The chart below shows the interest rate sensitivity since early November 2020 and shows that Nasdaq 100 significantly underperforms the MSCI World on days with the US 10-year yield moving higher by more than 5 basis points, while the STOXX 600 Index is outperforming global equities. This gives you clues about that blending US and European equities during rising US interest rates is a good idea. Our performance year-to-date across our theme baskets also suggest that commodity sector (energy, mining, chemicals and agriculture, defence, and logistics) can lower your equity duration.

Finally, the leading expert on equity valuation, NYC professor Aswath Damodaran, put out in March 2021 and good table overview of the impact of rising interest rates on equities. The key is to figure out whether interest rates are rising because of higher real growth expectations or higher inflation. If it is the latter then it is clearly more negative for equity valuations.

Source: Aswath Damodaran

Sea Ltd hit by Tencent divestment and profit angst

We have written about Sea Ltd before leaning on the more critical side than equity analysts covering the stock and bullish investors. The company is essentially using its cash cow in mobile gaming (which by the way is very dependent on a few assets) to fund its aggressive move into e-commerce, which is costly as Sea has opted for an aggressive price promotion strategy that is causing losses in its e-commerce unit. Sea has had massive success in Southeast Asia and is now taking the model to more distant places such as South America, but the company is increasingly experiencing competition from other players in gaming and e-commerce, and since the peak in October last year, the stock is down 51% and lost 6.6% yesterday is the heavy technology selloff.

Yesterday, Tencent announced that it has sold $3bn worth of shares taking its ownership down to 18.7% from 21.3% and voting rights below 10%. The move follows previous moves by other Chinese technology companies that under the new technology regulation is urged by the government to divest interest across many industries in order to reduce anti-competitive behaviour. While Sea is growing fast and can arguably become a very profitable company investors are likely changing their risk preferences in relation to profitability, forcing fast-growing companies such as Sea to move faster toward break-even and as such much is at stake for Sea in the upcoming earnings season.

Source: Saxo Group
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