How to survive the ‘bondcano’ market

Low interest rates are a supporting factor for the stock markets, but now they are rising sharply as central banks catch up to inflation caused by record levels of pandemic stimulus and war in Ukraine.

So, how is the Australian stock market ready to deal with what’s to come? Since the index is dominated by commodity producers who have traditionally performed well in an inflationary environment, that could position the market favorably.

However, the index is also highly cyclical and if global growth slows, the Australian stock market will certainly suffer. The plunge in the Australian dollar certainly reflects that reality.

Australia is often described as an economy of holes and houses.

So, what about the houses? Governor Lowe was asked about the impact of rising interest rates on the property market and he reiterated his view on the relative strength of households and of the banks lending to them.

This seems to indicate that the economy can cope with an inevitably weaker real estate market that will result from the rate hikes needed to bring inflation back under control.

price sensitive

So while asset prices are extremely sensitive to higher interest rates, we may be underestimating the sustainability of the economy in general. MST Marquee’s market strategist Hasan Tevfik has certainly taken that position.

He says corporate and household balance sheets in both the US and Australia are in good shape. He believes that non-housing-related consumption may hold up better than feared as rates rise, cushioning the effects of a global slump.

Based on this relatively strong position, he says the US 10-year inflation-adjusted bond yield could rise to 1 percent before a drag on growth worsens. That implies a nominal 10-year bond yield of 3.5 percent, which is almost approaching us.

Several years ago Tevfik coined the term “bondcano” to describe the ubiquitous power of long-term bond yields in the stock market.

Now that strength is ripping through the market and won’t slow down until inflation moderates or central banks calm the pace of tightening. We’re not there yet, but dramatic as they are, double- or triple-loop rate hikes could get us there sooner.

Until then, investors should proceed with caution. Tevfik remains obscure with the banks because he believes the real estate market will weaken. But the problem won’t necessarily be a surge in non-performing loans putting pressure on margins.

Rather, he believes it will manifest itself in stagnant credit volumes, which in turn will weaken earnings.

Tevfik is also wary of high-growth stocks that he says simply haven’t lowered enough to provide a level of comfort. The top quintile of stocks, measured by P/E ratios, is at 27.5 times, which is 30 percent higher than the average. History, he says, suggests that growth stocks will underperform until bond yields spike.

Also be careful with bargain hunting. Former market enthusiasts like Xero and REA Group may have solid balance sheets, but they still seem expensive, he says. Other discarded favorites, including Magellan, Domino’s and Sonic, are either expensive or show poor earnings momentum.

So, where do people look for comfort from the bond cano? Tevfik says there are companies in the out-of-favour materials, energy and industrial sectors trading on attractive double-digit free cash flow returns, which should make them relatively impervious to further interest rate hikes.

Among them are miners and energy companies such as BHP, Santos, Ampol and Viva.

These seemingly attractive free cash flow returns are either a sign of stocks that have been overlooked or oversold, or the market is predicting a decline in those cash flows as the global economy slows.

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