How risk-free interest rate can determine the valuation of investments?

11.07.2022

When we make our analyses of the financial markets, the departure point is always the same. We always start from the anchor point for all markets: the risk-free interest rate. It determines the valuation of shares and bonds.

Let us look first at the European Central Bank (ECB). At the end of last year, there was still no indication that the ECB would abandon its policy of official negative interest rates. However, the surge in inflation has turned out to be far less temporary than expected. To maintain the appearance that it wants to fight inflation, the ECB now also has to raise its interest rates. The first rate hikes will follow soon and the ECB is expected to raise the interest rate from the current – 0.5% to 1% by mid next year.

The US Central Bank (FED) has already started to aggressively adjust its interest rates. It recently raised its interest rates in one fell swoop by 0.75% to 1.5%. It was in 1994 that the FED last took such a large interest rate step. Thus, the FED has gone into full war mode to fight the inflation. Interest rates are expected to rise above 3% by early next year.

All segments of the financial markets have adapted to this new reality over the past six months.

Let us start with the bond markets. Yields on 10-year US dollar government bonds have risen this year from 1.5% at the start of the year to the current 3.2%. Yields on Germany’s 10-year government bonds have risen from -0.2% to 1.6% today. Over the past six months, these sharp rises in yields have resulted in negative returns of approximately 10% to 15% for bond investors who simply invested in indexes.

However, we have been able to significantly limit the damage to our bond portfolios thanks to:

  •  the relatively short duration of our portfolio,
  •  having a wide international spread in which we have benefited from the weakening of the euro, and finally
  •  our approximately 40% allocation in inflation-linked bonds.

Corporate bond yields have risen even more than government bond yields due to fears of an imminent recession and the announced end of the ECB purchase programme. The interest rate differentials between government and corporate bonds have widened to such an extent that we see many opportunities in corporate bonds today. Corporate bond yields can now even reach around 5%. We have therefore recently increased the weight of these corporate bonds in our portfolios.

Finally, the equity markets have also had to process these interest rate rises. Coupled with fears of an imminent recession, this has led to a sharp correction in the stock markets. The S&P500 has fallen by approximately -20% since the start of this year. The Euro Stoxx 50 index by a comparable approximately -17%. But given that corporate profits have not fallen, stock market valuations have fallen sharply. The P/E ratio of the S&P500 has fallen from 22 at the end of last year to approximately 15 today. Or conversely, the E/P ratio (or earnings yield) has risen from 4.5% to 6.6%. In Europe, earnings yield has even risen from 7.6% to 9%. Thus, it seems that the markets are already expecting a sharp recession.

Conclusion

Our focus on companies with strong balance sheets coupled with strong free cash flow generation is always a winning strategy in difficult financial markets. The downward correction of companies that generate little or no cash flow is very pronounced. Our robust portfolio, well diversified across some 75 companies, draws its strength from those 75 engines that together generate more than 600 billion US dollars in free cash flow in 2022.

If you invest on the long terme, your patience will be rewarded in time. After all, there is a very clear silver lining that is taking shape on the investor horizon. For the first time in more than 10 years, one can again expect a decent return for the bonds part. The expected return for a bond portfolio once again lies above about 3% for the coming 5 to 10 years. And the earnings yield on the equity investments has also risen by almost 2%. The average of the earnings yield in the US (6.6%) and Europe (9%) is currently close to almost 8%. The patient equity investor with a 10-year horizon will be rewarded.

You may also have noticed that, in this newsletter, we are not really saying much about the short-term outlook. The expectation, or perhaps rather the hope, is that inflation will cool off sharply towards the end of the year. However, it is impossible to say whether this will actually be the case. The war in Ukraine may yet produce surprises. If inflation does indeed cool off towards the end of the year, we can reasonably expect a recovery in both equities and bonds portfolios. Otherwise, as always, our team is ready to respond to any market volatility.

We continue to monitor the markets and your portfolios closely and will keep you informed of further developments.

Yours sincerely,

The Management and staff of CapitalatWork Foyer Group SA

 

Disclaimer: This document is an informative communication tool. It does not constitute personal advice, an offer or solicitation to buy or sell, nor to participate in an investment strategy. The content is based on information sources believed to be reliable. The information presented may be changed without prior notice. Please contact CapitalatWork (https://www.capitalatwork.com/en) for further information regarding the risks associated with the financial instrument. Before taking an investment decision, the investor is advised to determine whether the proposed investment is suitable for him or her, taking into account his or her knowledge and experience of investment, investment objectives and financial situation. Past performance is not a guarantee of future performance. All rights reserved. No part of this publication may be copied, stored in an information system or forwarded in any form or in any way (mechanically, by means of photocopying, recording or otherwise) without the prior consent of the copyright holder.

 

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