Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the reflation, mortgage rates rise, Deliveroo’s IPO, and a look at equity duration during a pandemic. To sign up for the Capital Note, follow this link.
The Reflation Is Here
Investors are selling bonds in droves on the expectation of higher inflation. The U.S. ten-year yield now stands at 1.5 percent, near its pre-pandemic level, following a 10 percent decline in ten-year Treasury prices. The magnitude of the sell-off mirrors 2013’s so-called taper tantrum, when a pullback in Federal Reserve asset purchases sent bond prices plummeting.
This time around, the dynamic is reversed: Investors are responding to an overly accommodative central bank, betting that growing aggregate demand will push inflation up. That’s tempered partially by a change in interest-rate expectations. The Fed has guided near-zero rates until roughly 2024, but investors have priced in three rate hikes by the end of 2023, betting that a persistent inflation overshoot will shake the Fed’s commitment to accommodative policy.
With U.S. retail sales posting a record jump last month while producer prices rose, supply and demand appear likely to be imbalanced this year.
For their part, central bankers have dismissed inflation concerns. Fed chair Jay Powell played down inflation concerns in his Senate testimony last week, and redoubled his commitment to holding interest rates low for the foreseeable future.
So far, the winner of the “reflation” have been macro hedge funds. The Financial Times reported this morning that the big-name macro funds have posted record gains this year:
Caxton, which last year posted its best ever returns, has gained 7.2 per cent in its Macro fund, run by Law, and 4.5 per cent in its main fund this year, according to an investor.
Meanwhile, Odey’s European fund, managed by founder Crispin Odey, gained 38.4 per cent last month, according to investor documentation seen by the FT, taking gains this year to 51.1 per cent. The fund has been running large bets against UK and Japanese government bonds. The firm recently wrote to clients to say it expected US inflation at 10-to-15 per cent this year.
The losers so far: tech stocks. Low bond yields lengthen the time-horizon for stock valuations — called “equity duration” — because earnings far into the future are more valuable when interest rates are low. The tech-heavy Nasdaq has lost 6 percent over the past two weeks, halting what seemed like an inexorable rally in tech stocks.
Cathie Wood’s Ark Investment Management, which offers actively managed tech ETFs, has hit a road bump after posting triple-digit gains last year. The Wall Street Journal reports:
The ETFs suffered double-digit percentage decreases last week, their biggest routs since the stock market’s plunge last March, according to FactSet. Further declines among growth stocks on Tuesday and Wednesday drove even deeper drops among ARK’s funds, bringing the declines for its flagship ARK Innovation ETF to 14% over the past month.
The cascade of red has proved hard for many investors to stomach. ARK’s funds collectively lost more than $1.8 billion between Feb. 24 and Monday, their biggest stretch of outflows ever, according to FactSet. Together, they managed roughly $51 billion at the end of February, making ARK the ninth-largest ETF operator. That’s after attracting $36.5 billion in assets over the past year, more than Invesco Ltd. , Charles Schwab Corp. and First Trust—the fourth, fifth and sixth biggest ETF issuers in the U.S., according to Morningstar Direct.
Wood is doubling down on growth stocks. After last week’s sell-off, she announced she’d bought more shares of Tesla.
The question now is how high bond yields can go. Many of the macro funds that bet on a reflation have closed their positions, and Wall Street analysts have cast doubt on the potential for a serious overshoot.
Around the Web
30-Year Mortgage Rate Tops 3% for First Time Since July
The average rate on a 30-year fixed-rate mortgage rose to 3.02%, mortgage-finance giant Freddie Mac said Thursday. It is the first time the rate on America’s most popular home loan has risen above 3% since July and the fifth consecutive week it has increased or held steady.
Mortgage rates fell throughout most of 2020 after the Covid-19 pandemic ravaged the economy. That helped power a boom in mortgage lending, fueled by refinancings. When rates hit 2.98% in July, it was their first time under the 3% mark in some 50 years of record-keeping.
Deliveroo is targeting a price tag of as much as $10bn in its initial public offering, according to people briefed on discussions at the food delivery group, giving London its most valuable new listing for several years. If the London-based company completes the float at the top of its target range, giving it a market capitalisation of more than £7bn, Deliveroo would be worth more than Sage, one of the few FTSE 100 tech companies, and The Hut Group, the ecommerce group that did the largest UK IPO for five years in 2020.
Berkshire is spending more of its $138 billion in cash on smaller investments, as opposed to deploying it on the huge acquisitions that he famously made in the past. The conglomerate bought back nearly $25 billion of its own shares last year, a record for a company that until recently was reluctant to spend its cash this way.
With “long-duration” stocks selling off, today’s Random Walk takes us to a recent paper from the University of California, which looks at the sensitivity of stock prices to pandemic shutdowns.
Implied equity duration was originally developed to analyze the sensitivity of equity prices to discount rate changes. We demonstrate that implied equity duration is also useful for analyzing the sensitivity of equity prices to pandemic shutdowns. Pandemic shutdowns primarily impact short-term cash flows, thus they have a greater impact on low duration equities. We show that implied equity duration has a strong positive relation to US equity returns and analyst forecast revisions during the onset of the2020 COVID-19 shutdown. Our analysis also demonstrates that the underperformance of ‘value’ stocks during this period is a rational response to their lower durations.
In short, companies that generate more-near-term cash flows suffered greater losses than those whose earnings are expected to materialize in the future. This explains in large part why tech stocks — which are valued on longer-term earnings, and many of which are cash-flow negative in the near-term — performed so well during the pandemic.
The same framework can be applied to any macroeconomic disruption. Low-duration stocks significantly underperformed during the 2008–09 financial crisis, for example. This is why it can often seem that the stock market is “disconnected” from the real economy: The more long-duration stocks in the market, the less sensitive it is to macro factors.
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