Higher yields – Not necessarily bad for equities

Data reports for the period were solid, showing no particular signs of an economic slowdown. As expected, the Federal Open Market Committee increased the federal funds rate by 25 basis points (to 2-2.25%) after its September meeting.

Fund Commentary
24 Oct 2018

Data reports for the period were solid, showing no particular signs of an economic slowdown. As expected, the Federal Open Market Committee increased the federal funds rate by 25 basis points (to 2-2.25%) after its September meeting.

The Fed reiterated the evasiveness of the neutral rate, and its strong reliance on data. In other words, the Fed will continue to increase rates until a slowdown sets in, not merely until the rate hits an approximate estimate of the neutral rate. These two factors shifted market expectations, pushing the 10Y Treasury yield higher.

The question is how this could potentially impact equities? As real yields are responsible for much of the move, and inflation expectations are stable, the Investment Adviser believes that the bond market is focussing on re-rating US economic growth higher. As long as signs continue to point to a growth-driven move in yields, stocks should fare well. Historically speaking and from a fundamental perspective, with economic growth at the fore, EPS growth tends to be positively correlated with changes in yields. However, when yields experience large changes in a short period of time, stocks can struggle to digest these moves. This said, yield-related headwinds tend to be short-lived in the team’s opinion.

As has been mentioned in previous commentaries, the Investment Adviser continues to expect the market to post gains through to the end of this year and into 2019. According to the team, a rising yield environment, even one where the yield curve is flattening, is one which is good for equities. Given the Fed’s strong commitment to transparency, a protracted series of rate shocks as damaging as in the 1994 period seems unlikely to the Investment Adviser.

At the fund-level, Broadcom (AVGO) was the largest monthly contributor to performance* (+0.39%), followed by Union Pacific Railway (+0.19%) and ULTA Beauty (+0.15%). On the other hand, Celgene was the largest detractor (-0.20%), followed by Financial Select Sector SPDR (-0.19%) and AO Smith (-0.17%).

Broadcom had a solid third quarter, with both sales and EPS reported above consensus estimates. Wireless and Storage outperformed expectations, whilst Industrial & Wired underperformed. The FQ4 outlook is also strong, with revenues slightly above expectations and EPS largely above expectations. According to the Investment Adviser, the outlook has thereby been positively influenced by higher margins and a substantially lower number of shares due to the $5.4B repurchase plan issued following the announcement to acquire CA Technologies and the subsequent stock decline. Even though recent volatility was painful, management has been proactive in the Investment Adviser’s opinion, with many points addressed during the call as summarised below:

  • Most importantly, management explained the strategy behind the deal in a credible manner.
  • Leverage targets have been relaxed with buybacks being the priority as long as the share price remains depressed. Margins continue to improve (currently above 50%).
  • Management seemed very confident in regaining orders for the Radio Frequency (RF) socket they lost in this year’s Apple cycle (with management’s outlook pointing to a return to double-digit growth in wireless by 2020).
  • The dividend growth story is still in place with a $9-$10 payout on the cards.
  • And finally, the Investment Adviser believes that estimates should continue to increase next year post the CA deal and that the stock remains cheap, offering what the team perceives to be a compelling risk/reward profile at current levels.

Celgene’s stock price has been grounded for some time now due to the Revlimid patent situation, modelling the entry of generic by consensus in 2023, while the buy side is concerned with a potential earlier entry. 3Q18 saw a modest improvement (stocks increased from $79 to $89) as the sector rebounded as a whole. The Company announced top-line Luspatercept success and more importantly, there was no negative news.

Nonetheless, the major tail/headwinds for the Company’s valuation are pipeline events. The Investment Adviser expects another good quarter, but the stock impact will most likely stay muted as near-term earnings are not the main subject for this Company. The team believe in Celgene’s pipeline potential, at the same time accepting that it is further on the risk/reward front.

All in all, the Investment Adviser believes in the current portfolio’s absolute and relative attractiveness going forward. As the environment becomes more volatile, maintaining exposure to quality names that have moats and strong individual earning growth catalysts will be crucial.

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 12/10/18 and are based on internal research and modelling.