Is inflation coming? These are the ASX stocks to buy if yields rise
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The ructions in global bond markets may force ASX investors to assess what stocks to buy if yields rise.
If that happens, UBS says a category of stocks it calls “Defensive Growth” is the group best-placed to outperform.
The analysts based their view on a framework that aligns rising bond yields with an increase in economic growth.
Effectively, stocks will be better placed to absorb the impact of higher yields if it’s accompanied by data that supports the current trend of a broader economic rebound.
However, “if the Australian 10-year yield reaches 2% without any further material improvement in the economic outlook, we would be tactically overweight stocks in the Defensive Growth list”, UBS said.
The stocks in the “Defensive Growth” basket are companies that can benefit in an environment where the economy is rebounding and yields are rising.
That differs from high-growth tech sectors such as BNPL (in Australia) and the companies that make up the US NASDAQ index — both of which have sold off sharply at the start of March.
A feature of companies such as Afterpay (ASX:APT) is that their valuation is based on much higher levels of future cash flows compared to what they make now..
And a defining aspect of markets in 2020 was that interest rates were anchored at rock bottom, as the global economy picked itself up off the mat from the pandemic.
As UBS says: “high future cash flows become more valuable when discounted using a lower risk-free rate”.
Government bond yields are the generally accepted risk-free rate and if they climb, it can prompt an investor re-rating.
Accompanying the jump in bond yields over the past two weeks (and a new capital raising), Afterpay shares haven fallen from a high of $160 to around $115 — almost 30 per cent (still an impressive gain from their March 2020 lows of $8.10).
But it’s clear that jumpy bond markets have brought the I-word (inflation) back to into the fold, after it sat in time-out for a solid 12+ years following the 2008 financial crisis.
Now, a gauge of inflation expectations run by the US Federal Reserve is forecasting CPI growth to reach 2.5 per cent for the first time since (you guessed it) 2008.
The prospect of higher inflation has been on the radar of pro investors since news of a positive vaccine first arrived last November.
By medical standards, the vaccine approval process was done with impressive speed. And it reset the outlook for how soon major economies could return to activity and growth.
It also marked the first sign of possible tension between an economic rebound, and the ultra-easy monetary policy being deployed by central banks to help manage the crisis.
US 10-year bond yields — the global benchmark — rose above one per cent in January for the first time since March 2020 when the crisis hit.
“I do think the underlying drivers of that theme (higher inflation and yields) are the highest likelihood of playing out that they have been for a long time,” Oracle’s Luke Winchester told Stockhead at the time.
Over the last two weeks, the rise in bond yields became much more pronounced.
And as UBS noted in recent research, it’s not so much rising bond yields but the speed at which they rise that can catch equity markets off guard.
All eyes turned to US Federal Reserve chair Jerome Powell on Thursday night to see what he had to say about the prospect of rising inflation.
Powell said he wasn’t too worried about it, and said the Fed would be patient in winding back the stimulus taps.
For its part, the RBA is holding firm to its view that rates won’t rise until 2024 — still another three years away.
On the one hand, the central bank forecast may be correct — inflationary forces could turn out to be transitory, and CPI growth will remained contained.
But as markets reassess the outlook for what happens next, the volatility of the last two weeks may also become more prevalent.