What do rising yields mean for stocks, should you buy the dip?

Hi guys, yeah, we're joined by Eddie Dommez here. I thought I'd bring you in, Eddie, because I wanted to get your views. Basically what we have here is we've got US stocks down sharply again today. This is actually the 6th straight down day in a row, and actually you'd look at it and say it's pretty much the biggest down sort of period we've had on stocks since the kind of COVID pandemic blew up back in quarter 1, quarter 2 of 2020. So a lot of the press are kind of pinning this situation on this idea that yields are rising. Can you explain this? Why are yields rising?

Yeah, I think it's a less sinister thing than people think, to be honest. I think the actual— when you hear inflation, it's normally associated as a kind of bad thing. It's a kind of dirty word. People get scared of it. I think for this reason, you know, we've got lockdowns easing, you know, global growth about to return. As you mentioned, lots of money ready to be put to work. And I think it's actually the expectation of global synchronized growth as we kind of emerge from the ashes of this kind of COVID pandemic. And actually, economists at Goldman are expecting a 6% global GDP number in 2021. And that's actually the strongest in 30 years. So that's, that's a pretty, pretty hefty number. So yields are rising because of this synchronized global growth story.

Okay, and how do you think though that's— okay, 6% upside for GDP in 2021, I mean, it doesn't really make up for the sharp downside we saw in 2020. So given that this is just kind of filling some of that COVID GDP decline, Why is it now investors are getting all excited about this, this yield play?

Yeah, I think there's a, there's a lot of things kind of at work here. So we obviously got this, this global GDP uptick, uh, lockdowns easing, but let's not forget the onslaught of monetary stimulus that got put on last year, both from a monetary perspective, and like you saw with Jay Powell today there's no easing up on those, on those, keeping those rates, uh, and then thus yields low. Uh, we've also got, um, fiscal expansion. So we had $900 billion in Q4 of last year, and then another $1.5 billion probably gonna, gonna pass. So you've got all of that global—

I guess this is right, thinking about it. Look, you've got on that central bank side, that, that is you know, so much kind of stimulus coming through. And with that fiscal stimulus, this double whammy, which is really driving what people are talking about, is the, the inflation expectations are rising. And I guess that's one key theme that's, that's driving yields higher. But obviously stocks are taking it badly here over the last few days. Do you think this is the top of the equity rally?

Well, if you are Sam North, buy the dip. But, um, so yeah, I think first of all you need to break down, you know, why is it bad for stocks, essentially? Higher yields, that is. So higher yields, um, when you're forecasting the cash flows of a company, okay, an asset, or even a financial instrument like bonds, higher yields and inflation— let's say inflation erodes that the future cash flows of those assets when you discount them back to today. And when you look at all the kind of names, speculative names that teenagers have been YOLOing those deep-levered, out-of-the-money call options on, and there's been a huge speculation with Tesla, Bitcoin, Plug Power, all those renewable energy companies. Those companies are hugely speculative in the sense that investors are paying a huge amount for future earnings, right? And these earnings are not coming in 2022, not in 2023. In some cases, this may be a 2025 or 2030, uh, 2030 story. Um, so when those yields start to rise, you know, those cash flows are really uncertain, uh, and those infla— inflation starts to bite there. So those speculative assets that have a huge proportion of the cash flow generated in the future are really going to feel the pain. And you're seeing it actually today with Tesla, obviously, Plug Power, all those renewable energy stories, autonomous taxis, all those really future-looking stories. Especially a good speculative trade recently has been the ARK ETFs. And this is the innovation ETF and genomics. They're really suffering today.

But you can't tell me that a multi-decade secular shift towards renewable energy is being derailed by short-term concern that inflation and yields might be rising.

Yeah. This is a secular trend. This is not going to go away. But when you're Tesla or you're Plug Power and you're being valued at— OK, let's say the S&P 500 earnings, price-to-earnings ratio is 15 times. Tesla's at 1,000 times. Plug Power's at something similar to that. All these speculative names are being valued at such high proportions of earnings, there's kind of that some element of mean reversion in the sense of, okay, let's take a breather here. You know, we've, we've come up a lot. Some of these names are up 500%, 1,000% in the last year. This is not derailing the whole story, but it's causing investors to really go, actually, you know, should we be paying 1,000 times?

Right. And I think looking at these big indexes like the S&P, like the NASDAQ, you know, it's obviously not just these very speculative sort of long-term plays. You've got some solid giant multinational businesses in these indexes that are coming off sharply. I guess it's a slightly different story on that inflation side, just thinking about companies like the Apples of this world that carry a huge amount of cash. So rather than future cash flows, it's actually cash that they currently have on the balance sheet. And I guess inflation rising results in the value of that cash being kind of revised down in future years, right?

Yeah, I think with the Apples and the Amazons, look, these are not the Plug Powers. These are generating serious earnings now, right? They're not, uh, something to be taken lightly. However, there's a— that reflation trade that I'm sure you can tell us a bit more about. There's going to be some asset allocation and some movement away of, okay, you know, we've had a great 10 years in these technology names actually, we're seeing a pickup in global growth expectations. Let's take some of our winners here and put it towards an ExxonMobil or a cyclical name that's going to benefit from this global growth expectations. But I guess for the people that haven't watched your very famous podcast, could you talk about the reflation trade and kind of what that means?

Yeah, just kind of briefly. I mean, the whole reflation trade is born around the thesis where 2021 is the emergence from COVID It's where the global economic system comes out of lockdown. And what you have is several factors all coming together. So that is monetary and fiscal stimulus, okay? You've then got people coming out of lockdown where they've been pent up and frustrated, and people are going to get out there and they're going to spend a lot of money because they just want to get out and release and have a good time. And I think what— and so that's the demand side is going to rise quite sharply, we predict. At the same time, when you think about the supply side, we also anticipate that the supply levels are too low to perhaps meet this spike in demand on the supply side, low because A, businesses have been destocking during this crisis, and B, there's been supply chain constraints that are also in place. So we're looking at a demand spike with low supply fueled by fiscal and monetary stimulus and people coming out of the jail of their house to kind of just get out there and let loose. Okay, and all of this we're expecting to drive that 6% upside in GDP in 2021. Now we're expecting that to all result in inflation rising, okay? And so this reflation trade is absolutely all about these cyclical, or just sectors that benefit from cyclical growth plus increased in inflation, plus stuff like increase in the kind of steepness of the yield curve. So you've got cyclical stocks, energy stocks love inflation, you've got banks that love that yield curve steepening. And this is the kind of play that's really been in the mix, I'd say, for ever since Biden pretty much won the election, or even before the election when it started to become clear he would win. This kind of whole reflation trade began. And obviously then coupled with that back in November, not just the Biden thing, but vaccines started to really come out. And okay, actually we've got some vaccines here that can get us out of this COVID crisis in 2021. So that's the reflation trade. But whilst that all sounds very positive for stocks, and certainly those ones I mentioned, what you're getting today is the opposite in terms of stocks are selling off. So it doesn't quite marry together with that reflation thesis. So that's why it's unusual. That's why I think on the one hand, whilst the broader indices are lower, this is a buying opportunity for a reflation trade scenario. But separate to that is, yes, some of these certain names have gone into almost like bubble-like territory where valuations have gone crazy. And I think inevitably the— to use the inflation— the inflated bubble is just kind of deflating quite rapidly on some of those names.

Yeah. And I think you're seeing that in the composition of the indices. You're seeing the NASDAQ down 2.3% and the Dow, for example, down 70 basis points. So that's that secular and the sector composition and the difference between them. Got a good, uh, fact for you is historically actually the best returns for, um, for stocks have actually come when there's low inflation and lower bond yields together, um, and then there's been inflation ticking up because of the stronger growth expectations. Why? Because as you've mentioned a lot of times before, yields are not at 6%, they're at 1.5%. if that. So rates are actually still low enough to support risk assets while playing into the reflation trade scenario.

Yeah. Two things to say to wrap. Just your point about the different indices. So the Dow is better off relatively today. Did you see where the FTSE 100 closed? Up 0.2%. So the FTSE is packed full of energy names and banks, right? So that's kind of— and there's no kind of tech and bubble-like kind of tech-type kind of stories in that index. The other point I wanted to make was then just how, you know, I think that in, in the end, this is a lot— this is volatility, right? This is short-term volatility. And in the end, the, you know, the Fed are kind of staying super dovish. And whilst there's a lot of volatility playing out here, you know, I think that this correction in many ways is quite healthy, ironically, for the kind of more medium-term uptrend that indices like the S&P 500 have got going on. So I don't think this is the top for the S&P 500 in 2021. And I think there's still more room to go on the upside, I'd say, but certainly makes it interesting. And we love a bit of price action.

Definitely. Cool, cool. Well, thanks for that, Piers.

No worries, catch you later.

Take care.