I freely admit that I have a behavioral weakness based on affirmation bias, especially when it comes to my big investment themes. In simple terms, I tend to hunt out those research and strategy views that affirm my core view, especially when it comes to a New Normal for interest rates.
Having got that admission out of the way I can now report on the latest research note from Cross Border Capital – which handily backs up my core conviction that interest rates will be back around zero in the US within the next few years.
Cross Border has been busy crunching the bond market dynamics and concluded that US Treasury yields are rising and that the yield curve is currently seeing a “bearish flattening, with short rates increasing faster than long rates…..The recently flatter yield curve has resulted from four drivers: (1) rising US policy rates; (2) falling yield volatility; (3) tighter US domestic liquidity, and (4) net international demand for US Treasuries.”
What follows is a frankly complex unpicking of the components of bond returns – focusing very much on term premia and tenor. Without going into phenomenal detail (and there’s plenty of that), Cross Border observes that we need to unpick term premia by their distribution by the tenor. “The pattern of buying and selling along different parts of the yield curve reflects the risk-seeking and risk-avoiding behavior of investors. This may be affected by liquidity, but it could also be influenced by other factors too”.
Using this analysis Cross Border suggests that the bulk of the movements in the US yield curve are dominated by term premia and these derive from liquidity factors – and that periods of rising Treasury yields and flattening yield curves “often end badly for the real economy”.
The bottom line?
“The FOMC’s ‘dot plot’ diagram projects two further US rate hikes this year, three in 2019 and two more in 2020, taking Fed Funds to around 3¼-3½%. A weaker US economy in coming months would likely cap future rate increases to perhaps only another 50-75bp, so taking Fed Funds to a local peak of 2½%. We maintain a view that the US Treasury market should test 3½% yields at the 10-year tenor in the short term but set against this backdrop of prospective economic deterioration and lower-than-expected policy rates, US bonds could begin to rally thereafter.”
Which handily accords with my view: that interest rates in the US will peak somewhere between 3 and 4%, and that 10 year Fed yields will go above 3.5%; but that a slowdown will then heave into view; the direction of interest rates will then be down; sparking a move back into bonds again.
Tick all those boxes on affirmation bias.
One possible driver for higher interest rates might be increasing oil prices. I think claims of $100 oil are a bit fanciful – though not illogical – although we could see Brent stay consistently above $60 or even $70 a barrel for a lengthy period of time. That could be bad news for inflation hawks (or maybe good news as this could have been what they’ve always been secretly hoping for to justify their investment positions) who will be banging the table for sharper interest rate rises.
Higher oil prices, on the other hand, are good news for lots of other players, not least Saudi corporates. Currently, everyone in the global markets is obsessed about who gets the Aramco listing – which is a rather bizarre obsession given that it is almost certainly bound to be a terrible investment. A rather better bet may just to buy into a basket of diversified Saudi equities – which sounds a good idea until you realize just how difficult that is to actually implement for most investors who aren’t allowed to access the Saudi market directly.
The good news though is that a major ETF provider will soon be riding to the rescue. My colleagues on ETF Stream reported this week that “Invesco is rolling out Europe’s first Saudi Arabia tracking ETF in London under the Invesco brand name. The Invesco MSCI Saudi Arabia UCITS ETF (MSAU) will track the MSCI Saudi Arabia 20/35 Index. The index tilts towards materials and financials – not oil as one might have expected. MSAU will charge 0.50%. Index factsheet here. “
The underlying index is called the MSCI Saudi Arabia IMI Capped Index and “is designed to measure the performance of the large, mid and small-cap segments of the Saudi Arabia market. The index incorporates foreign ownership limit restrictions. The weight of the largest group entity in the index is constrained to 35% and the weights of all other entities are constrained to a maximum of 20%.”.
According to MSCI, the index dividend yield is 3.37% (vs 3.84% for the comparable GCC Countries index) while the PE is 17.87 (15 for the GCC states) with a forward PE of 15.24. In terms of performance, YTD returns is an increase of 18% but the three year annualised return is 2.38%.
Rather more ominously, the index looks horribly concentrated to me, especially in just two sectors – materials businesses comprise while financials top the list with a weighting of 39%. Big constituents in the index – and presumably the ETF – includes Saudi Basic Ind Corp 14% of index, Al Rajhi Banking at 11.20%. Then comes National Commercial Bank and Saudi telecom around 14.5% between them.