By Gary Black
The market’s sell-off in high-momentum stocks—biotechnology, internet, and cloud names, specifically—can be summarised in one word: duration. As every bond investor knows, when interest rates rise, long-duration bonds get hit the hardest because they are most sensitive to changes in interest rates.
Equities are no different. When Federal Reserve chair Yellen raised the specter of tighter monetary policy happening earlier than investors expected, the market’s reaction was swift and unambiguous: sell long-duration equities.
Long-duration equities are those where the vast majority of earnings and cash flows are many years out, and current-year earnings and cash flows are non-existent or negative. (Think of a technology company that reinvests all its cash back into its business to fund its rapid growth—where the anticipated payoff could be significant but many years out.) The stocks hit hardest in the recent sell-off were those where substantially all the intrinsic value is in the future “terminal” value (i.e. value based on cash flows that are 10, 15, or 20 years out). The prospect of higher interest rates cuts down the terminal values that drive growth stock valuations in the internet, cloud, and biotech sectors. These sectors were among the hardest hit yesterday and again today.
I believe that as Fed governors speak out and try to throw cold water on the market’s foregone conclusion that short rates will start rising as early as the spring of 2015—as implied by Yellen’s comments—the shift out of long-duration equities should reverse. We are likely to see a return of “bad news is good news”—that is, weak economic data reduces the odds of tightened monetary policy—which would cause long-duration equities to get bid up again.
Our research shows that over the past 35 years, the combination of negative real but low absolute interest rates at the short end of the yield curve and rising but moderate rates at the long end of the curve indicates an expanding economy without inflation. In such an environment, the technology, consumer discretionary, financials, and industrials sectors have tended to do best. We remain committed to the secular growth names our analysts have identified and believe they can benefit from secular tailwinds such as mobility, 24/7 access to information and entertainment, the emerging middle class, a global marketplace, aging demographics, productivity enhancements, and global infrastructure. At the same time, we remain disciplined about what we pay for companies that can benefit from these secular tailwinds, while being cognizant of the impact of rising rates on these longer-duration equities.
Gary Black is global co-chief investment officer at Calamos
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