T. Rowe’s Eiswert: Unwinding the yield-oriented bubble

Unprecedented monetary stimulus and historically low interest rates have been major catalysts for the resurgence in equity markets over the past six years. However, the magnitude of the accommodation by central banks, amid a persistently sluggish economic environment, has dramatically affected investor psychology and capital allocation decisions.

Market participants have responded to this stimulus with a deep pessimism for the global economy. One manifestation of this paradigm has been a market rally led decisively by defensive sectors. Investors have flocked to less volatile and higher-yielding equities, believing they would deliver bond-like volatility with equity-like returns. We believe this has given rise to a yield-oriented market bubble that is still unwinding today. Companies have shown similar caution with a reluctance to invest in their businesses, opting to cut costs and allocate their growing stockpiles of cash to share repurchases and dividend increases to satisfy investors and boost their stock prices.

Recently there have been signs of change in this approach to capital allocation, indicating animal spirits may finally be returning. With relative stealth, corporate management teams over the past year have embarked on what may become one of the greatest M&A sprees ever, taking advantage of cheap money while it lasts and the market’s favourable reception to deals. The stockmarket is rewarding and reinforcing this behaviour, as the stocks of both the acquirer and the acquired have risen on such announcements – an unusual development given the historical failure of acquisitions in terms of shareholder value creation.

Moving beyond a deflationary, defensive mindset to an inflationary mindset takes time, but it is already underway. One reason companies are acquiring each other at a record pace is precisely because the price of acquisition will be higher tomorrow and the quality of the target company likely less attractive. The more investors and companies become concerned with prices rising in the future, the more economic activity is pulled into the present. 

As we go through this transition, investors should consider how they want to be positioned for the next two or three years.

We think getting early to growing businesses that see profits and margins rise along with interest rates is the key – so we find large US financials attractive. This sector has faced stiff headwinds, but it is one of the few in the US market where valuations are historically low. While financial companies have been constrained in the amount of capital they can pay out, the tough regulatory environment should start to improve or at least stabilise. Leading banks will benefit from rising rates and volatility during the transition to a more inflationary economy, meaning better returns.

We also think a healthier global economy will benefit companies that have suffered from tight supply conditions after years of underinvestment, industry consolidation and capacity retrenchment. These include industrials, such as aerospace, transportation, non-residential construction, and home building materials firms.

We are also overweight technology and consumer discretionary stocks – areas where there is significant change, where industry structures and pricing can improve quickly. Many of our technology holdings are internet companies, where we see phenomenal change and real long-term economic benefits to successful innovators. The shifts toward greater connectivity, mobility, and use of cloud software applications are powerful long-term trends, and the markets for consumer and enterprise technology products are expanding in all regions. We have been underweight sectors that have benefited from the defensive yield trade, such as consumer staples, utilities, and telecommunications.

Innovation and the potential for medical breakthroughs have created investor frenzy for biotechnology, but stock valuations have reached levels that are bound, at some point, to lead to investor disappointment. We worry about a sector rotation out of biotechnology stocks, especially as other areas of the global economy show signs of life. Longer term, however, the healthcare sector is a fertile area for growth given the secular trends of an ageing population in developed markets and a wealthier population in emerging markets. 

David Eiswert is portfolio manager of the T. Rowe Price Global Focused Growth Equity Fund.