US bond yields are now back to levels last seen in 2011 as the Fed continues to signal further rate rises ahead to prevent the US economy from overheating in their view. Unusually, the US yield curve between 10 years and 2 years flattened as the 10-year yield rose (see first chart). That indicates the market is worried about the Fed potentially making the mistake of overtightening monetary policy, an all-too-common occurrence in past cycles.
However, the yield curve stopped short of inverting, with the spread between 10 years and 2 years bottoming at around +20 bps. The yield curve has since steepened a little to around +32 bps currently. An inverted yield curve, where short rates are higher than long rates, is a classic red flag for a recession in about 12 months’ time.
It is still possible that the yield curve might invert at some point over the next 12 months if the market thinks the Fed has lost the plot, but for now the yield curve points to the US economy slowing next year rather than going into recession.
In the absence of a recession or a wage break-out, US company earnings can continue to grow, albeit at a slower rate. Growth in earnings per share will be assisted by a record amount of share buybacks.
Rising bond yields also impact the equity risk premium (ERP) – the expected return from equities above the risk-free rate required to compensate investors for taking on the higher risk of equities compared to bonds. The slimmer the ERP gets, the less justification there is for taking equity risk.
So where does the US ERP stand at the moment? The current 12-month forward PE ratio for the S&P 500 Index is 16.56x based on Bloomberg consensus forecasts, having come down from a peak of 18.3x in November 2017. That is equivalent to a forward earnings yield of 6.04% (i.e. 100/16.56). After subtracting the US 10-year Treasury yield of 3.21%, that gives a US ERP of 2.83%.
That is a fairly slim ERP but, as the Oaktree report featured in Tuesday’s Daily Note pointed out, low interest rates in many parts of the world have caused investors to move into riskier investments to generate acceptable returns, driving down risk premia in the process. The current US ERP compared to history can be seen in the chart below.
A structural reduction in risk premia is possible but “this time is different” is said to be the most expensive phrase uttered by portfolio managers. A sub-3% ERP should be considered as flashing an amber signal and a sub-2% ERP should be considered as flashing a red signal.
The last time the US ERP was lower than 2% was in 2007 on the eve of the Global Financial Crisis.
Marcus Tuck – Head of Equities
Australian Miners – Goldman Sachs – Investment discipline generating superior returns; Buy BHP & RIO
BHP and RIO implemented new return-focused strategies in 2015. Since then, gearing has dropped to record low levels, and FCF and ROCE have improved significantly. Only the highest returning projects are being developed within more measured capital budgets. M&A discipline is holding and management is regaining trust through consistent shareholder returns. While the new return-focused strategies were set in motion in 2015, they are just starting to pay off in the form of higher shareholder returns while still growing production and expanding margins.
With a mostly supportive demand-supply backdrop and a positive view on commodities, GS expect the majors to recover from their low valuation multiples back to long-term averages and to continue their re-rating. Despite record FCF and improving returns, the large global mining companies are trading on an average EV/EBITDA multiple of just 5x, below the historical average of 6x. BHP and RIO are trading on just 5.3x versus the 20-year average of 7x, and 8x during the last major boom from 2001-2008. GS’s key stock ideas in the sector are as follows:
BHP and RIO are positioned for c.15% re-rates over the next 12 months in GS’s view, based on multiples that are compelling versus history. GS rate BHP a Buy (target price A$41.00) and upgrade RIO from Neutral to Buy (target price A$91.00). Both stocks are trading at discounts to GS’s NPVs, have high-returning (>15% IRR) production growth (2% p.a.), improving EBITDA margins (c.50%), compelling FCF yields of 12% for RIO and 8% for BHP, and potential for further non-core asset sales (US$10-15bn). The effective dividend yields for both stocks are 8-10% when including buybacks, which should drive a 5-8% increase in GS’s NAVPS per annum for both companies.
GS downgrade South32 (S32) from Buy to Neutral and cut their target price to A$3.80 as the stock is trading at 1.2x NPV, pricing in spot commodities and FX until the end of FY21, and has low FCF and declining ROCE over the medium term on rising capex.
GS initiate on Fortescue Metals (FMG) with a Neutral rating and A$3.90 target price. They expect neutral to negative FCF in FY20 and FY21 due to an increase in capex and sustained low product realisations for FMG’s 58% iron ore until their new higher-grade 60% product hits full production rates in 2020.