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It's a very, very mad world

It seems discount rates no longer apply to tech stocks
Steve Russell
Fund Manager

This month’s chart neatly captures the conundrum investors have faced this year: the stark disconnect between rising bond yields and the performance of other interest rate sensitive assets, especially the mega-cap technology stocks.

With inflation proving more persistent than central banks forecast, it has become increasingly clear that interest rates will need to be higher for longer – a point successive Fed members have recently been at pains to make. 

Not surprisingly, this has seen bond yields push higher, continuing the bear market in bonds that kicked off in 2022. US real yields (the difference between nominal bond yields and inflation) have also marched higher, shown by the green line (inverted scale on the right side) in the chart. The 10 year real yield has moved with shocking speed from -1% in 2021 to well over +2%. 

However, technology stock valuations, shown here by the PE ratio for the Nasdaq (blue line), have done the opposite, rising sharply even as real yields have surged upwards. This simply shouldn’t be happening. 

The relationship between bond yields and equity markets is normally a simple (and rational) one. As interest rates rise (particularly real rates), the discounted value of future profits drops, and so equity valuations tend to fall.

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As real interest rates fell during and immediately after the pandemic, the valuation ascribed to technology stocks rose, driving strong returns. All very straightforward.

Similarly, last year as central banks moved to combat inflation, real interest rates rose and the valuation on the Nasdaq fell sharply, leading the index to fall by roughly a third. Again, pretty straightforward.

In 2023, that relationship has been flipped on its head: bond yields have risen sharply, but equity markets – specifically, and counter-intuitively, those sectors most vulnerable to rising rates, such as technology – have defied gravity and continued upwards.

What could explain this? Will the growth from AI technology overwhelm the negative impact of higher interest rates? Perhaps, but not likely. Similar forecasts were made during the 1999-2000 dot.com bubble: the internet was going to change the way the world worked and drive huge growth for technology stocks. Well, that all actually came to pass, just a decade later than everyone thought. In the meantime, even the eventual winners lost up to 90% of their value. The losers went bust.

Alternatively, is government debt now so high that the US’s creditworthiness is in question? This may be true to some degree, but governments, and only governments, can always print money to pay interest and capital. They can also raise tax revenues. This is the US government after all, and, perhaps uniquely, it does have the power to tax the mega-cap tech companies if it so chooses. 

We believe a significant downward repricing of equities is required as markets adjust to a world where cash rates of 5% are a viable alternative to investing in risk assets. Whilst this repricing has largely already happened in bond markets, equities – and especially mega-cap tech stocks – remain in our view significantly overvalued. This risks another stock market crisis, against which the Ruffer portfolio holds significant protections. Taking a cautious view can sometimes be painful. But history tells us that, not long after these periods, the risks emerge, leading to significant drawdowns in markets.

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July 2023: In this quarter’s episode of Ruffer Radio, Chairman Jonathan Ruffer shares his perspectives on the evolution of Ruffer’s all-weather investment approach since founding the firm in 1994. Jonathan reflects on the genesis of the firm, making mistakes, the character traits that shape his investment style, and the challenges and opportunities facing investors today. And crucially, how these are reflected in the Ruffer portfolio.
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Is discretion the better part of valour?
June 2023: Whilst it’s been a tough start to the year for cautious investors, equity valuations – particularly in the US – suggest the rally could run out of steam, and cash now offers a tempting alternative. Moreover, with inflation stubbornly high, central bankers will be reluctant to intervene if markets encounter turbulence. Against this backdrop, we think caution is still justified.
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Chart source: Bloomberg, Ruffer

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This article does not take account of any potential investor’s investment objectives, particular needs or financial situation. This article reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. This financial promotion is issued by Ruffer LLP which is authorised and regulated by the Financial Conduct Authority in the UK and is registered as an investment adviser with the US Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. © Ruffer LLP 2023. Registered in England with partnership No OC305288. 80 Victoria Street, London SW1E 5JL. For US institutional investors: securities offered through Ruffer LLC, Member FINRA. Ruffer LLC is doing business as Ruffer North America LLC in New York. Read the full disclaimer.

London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France