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.