Strategic Series #1

RISING INTEREST RATES AND INVESTMENT STRATEGY

24 September 2013 Emmanuel FERRY Matthias JOUIN-SELLEZ

Key Messages Financial markets got into a new phase: 1. Long term interest rates are rising, anticipating an inflection of the US monetary policy

INFLECTION OF THE FED POLICY 1. 2. 3. 4.

The Fed announced on May 22nd the upcoming Tapering of the QE This marks a first sign of monetary policy inflection after a long period of very accommodative monetary conditions (Fed Funds Rates at 0.25% for 55 months) The Fed recalls an upward revision of growth outlook for 2014, a reduction of the risks of a lower economic activity and an improvement of the employment The Tapering should start by the end of 2013 and the first Fed Funds Rate hikes would not start before 2016 The Fed remains very pragmatic and the normalization process will be progressive: the pace of the Tapering will be « data dependent » and « fine tuning » will be favored

2. USD is strengthening

5.

3. Equity market keeps appreciating

FIRST LESSONS

4. The main driver will be the EPS growth, the valuation effect is losing momentum but remains positive

3.

5. Rotation towards the assets that are the most sensitive to the economic cycle, exit from the safe havens/ bond proxies

1. 2.

4.

Monetary policy tightening phases are always associated with higher volatility Assets inflated by the successive QE become vulnerable (precious metals, emerging debt, carry trades on high yield currencies, real estate) Three great rotations themes will set up: from Bonds to Equities, from Defensive to Cyclical assets, from Consumers to Producers The Fed watching will become the main focus of investors

WHAT INVESTMENT STRATEGY SHOULD WE ADOPT 1. 2. 3. 4. 5.

Dollar is getting back on an upward trend after ten years of continuing depreciation. This weakens precious metals and emerging currencies The focus should be on the equity asset class, particularly during the phase where long-term interest rates rise because of building expectations of monetary policy change The current phase sees a rotation from Bonds toward Equities Within Equities, Cyclical/Value sectors and Financial Sector should now be favored As long as there is no effective Fed Funds Rate hikes, a rise in Stocks can coexist with a fall in bond market 2

Section I

Investment Clock

Economic Cycle, Interest Rates Curve & Investment Clock Falling

Inflation

Rising

COMMODITIES

Cyclical Growth

Cyclical Value

Falling

Bull Steepening

Bear Steepening

Bull Flattening

Bear Flattening

BONDS Defensive Growth

SLOWDOWN

REFLATION

EQUITIES

Growth

Rising

EXPANSION

CASH RECESSION

Defensive Value 4

Section II

Interest Rates and Economic Growth

Long Rates and Nominal Growth 10

1800 1600

8

Long term interest rates rise but remain below the nominal US GDP growth.

1400 6 1200 4

1000

2

800 600

0 400 -2

-4 03/96

The equity market will keep on a positive trend as long as the GDP – Interest rates differential remains positive

200

0 03/98

03/00

US 10Y (LHS)

03/02

03/04

03/06

03/08

US Nominal GDP Growth YoY (LHS)

03/10

03/12

S&P500 (RHS)

6

Fed Funds Rates and Nominal Growth 10

1800 1600

8

The Fed considerably delayed the tightening of its monetary policy risking asset bubble feeding

1400 6 1200 4

1000

2

800 600

0 400 -2

-4 03/96

The equity market will keep on a positive trend as long as the GDP – Interest rates differential remains positive.

200

0 03/98

03/00

03/02

Fed Funds Target Rate (LHS)

03/04

03/06

03/08

US Nominal GDP Growth YoY (LHS)

03/10

03/12 S&P500 (RHS)

Assets Bubbles 1997: Asian bubble 2000: TMT 2007: Credit 2012: US Assets (Bonds then Equity market)

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Section III

Stock Market Performance in Rising Rates Environment

Anticipation of Monetary Tightening Phases – Long Term Interest Rates Behavior Period of Monetary Tightening

Upward Cycle on US Long Rates Fed Funds

Beginning Apr/1988 Feb/1994 Mar/1997 Jul/1999 Jul/2004

End Feb/1989 Feb/1995 Mar/1997 May/2000 Jun/2006

Low point (%) 6.8 3.3 5.3 5.0 1.3

High point (%) 9.8 6.0 5.5 6.5 5.3

Anticipation Long Rates Increase US 10y vs. before Effective FF Tightening Low point (%) High point (%) Delta (bps) Nb Months Nb Mois Bps 8.2 9.5 115 13 -2 30 5.4 8.0 148 13 -4 47 5.6 7.0 124 15 -14 112 4.8 6.8 141 15 -9 104 3.4 5.2 155 36 -13 109 US 10Y

Delta (bps) 144 185 105 130 420

Nb Months 10 12 0 10 23

Beginning Feb/1988 Oct/1993 Jan/1996 Oct/1998 Jun/2003

End Mar/1989 Nov/1994 Apr/1997 Jan/2000 Jun/2006

1

16

2

3

4

Long Rates Increase during Effective Tightening Bps 84 163 16 67 68

5

1 0.9

14

The role of long term interest rates is to anticipate the monetary policy of the Federal Reserve. Since the end of the 90’s, ( 3 4 5 ), the upward cycle on long rates starts on average 12 months before the first rates hike by the Fed

0.8 12 0.7 10

0.6

8

0.5

0.4

6

0.3 4 0.2 2 0 12/82

0.1 0 12/84

12/86

12/88

12/90

12/92

12/94

12/96

12/98

Phase of Monetary Tightening

Fed Funds

Beginning Upward Cycle 10-yr US

End Upward Cycle 10-yr US

12/00

12/02

12/04

12/06

12/08

12/10

12/12

10-yr US

9

Anticipation of Monetary Tightening Phases – S&P 500 Performance Period of Monetary Tightening

Upward Cycle on US Long Rates

Fed Funds Beginning Apr/1988 Feb/1994 Mar/1997 Jul/1999 Jul/2004

End Feb/1989 Feb/1995 Mar/1997 May/2000 Jun/2006

S&P 500 Performance between beginning of Long Rates Increase and Annualized Perf. first FED Rates Increase

US 10Y Beginning Feb/1988 Oct/1993 Jan/1996 Oct/1998 Jun/2003

End Mar/1989 Nov/1994 Apr/1997 Jan/2000 Jun/2006

4% 5% 22% 61% 13%

Mean Median

21% 13%

1

1800

Phases of rate hikes expectations by the Fed usually considered to be a signal of economic growth recovery that translate generally into a positive performance of equity markets. Conversely, periods of monetary tightening constitute a less favorable environment for stocks.

0% 1% 26% 41% 13%

2

3

S&P 500 Performance during Monetary T ightening

Annualized Perf.

11% 2% -1% 1% 13%

12% 2% -49% 1% 6% -5.5% 1.9%

4

5

1 0.9

1600

0.8

1400

0.7 1200

0.6 1000 0.5 800 0.4 600 0.3 400

0.2

200 0 01/83

0.1 0 01/85

01/87

01/89

01/91

Phase of Monetary Tightening

01/93 S&P 500

01/95

01/97

01/99

01/01

01/03

Beginning Upward Cycle 10-yr US

01/05

01/07

01/09

01/11

01/13

End Upward Cycle 10-yr US

10

Anticipation of Monetary Tightening Phases – Impact on Equity Valuation Period of Monetary Tightening

Upward Cycle on US Long Rates

Fed Funds Beginning Apr/1988 Feb/1994 Mar/1997 Jul/1999 Jul/2004

End Feb/1989 Feb/1995 Mar/1997 May/2000 Jun/2006

Phases of rate hikes expectations by the Fed have a mixed effect on valuations. On average, we note a slight increase of the valuation multiples (P/E). Then, the equity market performance can be essentially explained by earnings growth. In contrast, monetary tightening phase systematically translate into a P/E contraction phase

P/E Evolution between beginning of Long Rates Increase and first FED Rates Increase

US 10Y Beginning Feb/1988 Oct/1993 Jan/1996 Oct/1998 Jun/2003

End Mar/1989 Nov/1994 Apr/1997 Jan/2000 Jun/2006

End 15 22 21 31 18

Delta -1 -2 3 8 -3

Mean Median

1 -1

Beginning 16 24 18 23 21

1

35

2

3

P/E Evolution during Monetary Tightening Beginning 15 22 21 31 18

Delta -2 -6 0 -3 -3

End 13 16 20 27 16

-3 -3

4

5

1 0.9

30 0.8 25

0.7

0.6

20

0.5 15

0.4 0.3

10

0.2 5 0.1 0 01/83

0

01/85

01/87

01/89

01/91

Phase of Monetary Tightenning

01/93

01/95

P/E - S&P 500

01/97

01/99

01/01

01/03

01/05

Beginning Upward Cycle 10-yr US

01/07

01/09

01/11

01/13

End Upward Cycle 10-yr US

11

Anticipation of Monetary Tightening Phases – Sectors Performances Period of Monetary Tightening Fed Funds Beginning Apr/1988 Feb/1994 Mar/1997 Jul/1999 Jul/2004

End Feb/1989 Feb/1995 Mar/1997 May/2000 Jun/2006

Annualized Performance of Sectors between beginning of Long Rates Increase and first FED Rates Increase

Upward Cycle on US Long Rates US 10Y Beginning Feb/1988 Oct/1993 Jan/1996 Oct/1998 Jun/2003

End Mar/1989 Nov/1994 Apr/1997 Jan/2000 Jun/2006 Mean Median

Consumer Information Discretionary T ech

Financials

Utilities

Energy

-10% 39% 66% 13%

-29% -3% 0% 5%

-5% 25% 28% 26%

11% 16% 82% 14%

27% 26%

-7% -2%

18% 25%

31% 15%

2

2.2

3

Consumer Staples

Health Care

Industrials

Materials

T elecom Services

15% 35% 147% 17%

4% 25% 7% 12%

8% 25% 29% -1%

35% 22% 68% 20%

59% 13% 37% 23%

-23% -1% 70% 0%

54% 26%

12% 9%

15% 16%

36% 29%

33% 30%

12% 0%

4

5

1 0.9

2

During the anticipation phase, we note an outperformance of Cyclical sectors against Defensive sectors. This outperformance has a tendency to continue during the tightening phase.

0.8 1.8

0.7 1.6

0.6

1.4

0.5

0.4

1.2

0.3 1

0.2 0.8

0.6 12/90

0.1 0

12/92

12/94

12/96

12/98

12/00

12/02

12/04

12/06

Phase of Monetary Tightening

Cyclical/Defensive Ratio

Beginning Upward Cycle 10-yr US

End Upward Cycle 10-yr US

12/08

12/10

12/12

12

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