Interest rates and the valuations of rate-sensitive sectors such as technology usually move in opposite directions but that inverse correlation has broken down this year. As a result, Ruffer’s Steve Russell is predicting “a significant downward repricing of equities” to correct this anomaly and end the tech rally which “simply shouldn’t be happening”.
As interest rates rise – particularly real yields (the difference between nominal bond yields and inflation) – the discounted value of future profits drops and therefore equity valuations usually fall.
As chairman Jonathan Ruffer explained: “The earnings of a company growing at a slowly fading 15% a year will have a net present value of ‘x’ if discounted at 3%, but only 0.3x if discounted at 5%. Same company, same outlook, same stock – but applying the change in long-term bond yields should price it lower by 70%. That repricing is what hasn’t happened for technology stocks this year.”
Real interest rates fell during and immediately after the pandemic, while tech valuations climbed. Then last year real interest rates rose as banks moved from quantitative easing to quantitative tightening, and the Nasdaq plummeted.
This year, however, that relationship has reversed again, said Russell, an investment director at Ruffer. “Bond yields have risen sharply, but equity markets – specifically, and counter-intuitively, those sectors most vulnerable to rising rates, such as technology – have defied gravity and continued upwards. It seems discount rates no longer apply to tech stocks.
“We believe a significant downward repricing of equities is required as markets adjust to a world where cash rates of 5% are a viable alternative to investing in risk assets,” Russell continued.
“Whilst this repricing has largely already happened in bond markets, equities – and especially mega-cap tech stocks – remain in our view significantly overvalued. This risks another stock market crisis, against which the Ruffer portfolio holds significant protections.”
Timing the markets is always difficult and Russell said he cannot be certain when a re-rating of tech stocks might occur. “We identify something we consider to be inevitable and then position ourselves so that holding protection doesn’t hurt us if it takes longer than expected [to happen] and it always takes longer than expected.”
Potential catalysts could include a disappointment from any of the mega-cap tech stocks such as slower growth or regulatory hurdles. “They are priced to perfection,” Russell said. Current valuations assume that artificial intelligence will fuel their growth and that “they will be immune to regulation and economic cycles and immune to having a higher discount rate. That’s obviously nonsense”.
Other red flags for equities would be a recession, a pause by the US Federal Reserve, or a shock elsewhere in the system triggering a withdrawal of liquidity from equities as investors move to bonds and cash.
Ruffer is protecting its portfolio using credit default swaps (CDS). “During periods of stress in markets, they tend to rise in price quite dramatically when everyone scrambles to insure their debt positions,” Russell said.
CDS are not a direct hedge for equities, but they tend to perform well when equity markets fall, as happened in early 2020 and in 2022. Besides, “it’s not just tech stocks that haven’t repriced, corporate credit hasn’t either,” he noted. Ruffer has also bought put options on the S&P 500.
Ruffer has used VIX calls in the past when volatility has been artificially low, which was true for three or four years before the Covid crisis in 2020. After that, volatility was elevated above 20 until this year’s market recovery from spring onwards, when “volatility was pushed down to untenable levels,” Russell said. “Volatility sub 14-15 on the index is attractive to us.”
Yen exposure is another form of offset protection for Ruffer. The yen should strengthen if equity markets fall, bond yields plummet and if there is a pause on interest rates.