Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Growth investing and valuation dynamics under low interest rates
Peter Garnry
Chief Investment Strategist
Summary: In this research note we show the valuation dynamics in a low interest rate environment and how it particularly impacts technology companies with predictable free cash flows due to their market position. We use Microsoft as an example and show how an even small reduction in its free cash flow yield would lead to a 43% increase in its market valuation. The key risk is obviously related to the US 10-year yield and inflation expectations and such investors should be very focused on these two factors.
In yesterday’s equity research note we showed why US equities are actually attractive despite the recent rallies and the ongoing COVID-19 pandemic. Free cash flow generation is solid and still growing healthy among US companies and the low interest rates are pushing up valuations as it inflates the equity risk premium. As we also stated the key risk to this rally remains rates and inflation expectations so this should be on every equity investor’s radar. However, the valuation increase has been modest compared to the collapse in US 10-year yield from around 2% in late 2019 to around 0.5% today, so in our view the interest rates sensitivity for equities is probably modest at this point until we get above 1.5% on the US 10-year yield.
If the Fed intends to anchor rates at current or lower levels for the foreseeable future until employment has been restored and it is willing to let inflation run hot then the further decline in real yields will continue to support equities. In fact, under the assumption of very low interest rates for many years the equity market could go significantly higher driven by technology stocks as their predictable cash flows cause investors to value those stocks more like bond proxies.
Microsoft highlights dynamics with low interest rates
Microsoft is an interesting case of growth investing in a low interest rate environment. The company’s shares have a free cash flow yield of 3% compared to US 5Y yield of 0.2% with 5-year CDS (credit default swap – basically a market-based premium for insurance against bankruptcy) prices being 36 bps and 18 bps respectively. In another words, investors are getting a significantly better yield investing in Microsoft than the US government with only twice the bankruptcy risk.
Fixed-income streams from US Treasuries are very predictable and to some extend an investor could argue that Microsoft’s future cash flows are very predictable given its monopoly status in computer operating systems and a fast-growing cloud business. Using the assumptions above it would not be outrageous to contemplate Microsoft’s free cash flow yield declining to 2% which would mean a 43% increase in its market value. The reason it is not 33% is because of the net debt component when applying free cash flow yields based on the enterprise value.
The chart above shows how Microsoft’s FCF yield has declined from 16% in late 2012 to around 3% today. In hindsight it is almost unthinkable that a monopoly was priced at a 16% yield. In fairness the turnaround of Microsoft’s business and the venturing into the cloud business has increased the growth trajectory and lowered the variance on cash flows which together with the lower interest rates have caused investors to push the valuation closer to bonds. Microsoft’s valuation has only increased modestly since the yield collapse so if investors continue change their behaviour and expectations about future interest rates then valuation could increase much more from here.
From the current level of valuation of large-cap stocks such as Facebook, Microsoft and Google which are all close to the 3% FCF yield level the exponential impact on market value gets wild if the bond proxy valuation takes hold. As the chart and table below show the acceleration in the multiplication factor on free cash flows gets aggressive below 3%. Therefore, technology equities could increase much further as yields have gotten compressed everywhere forcing investors into stable high growth equities with predictable cash flows. Again, all these assumptions change rapidly with rising interest rates and inflation so investors should be aware of those factors. But it is worth repeating that we see little impact below 1.5% on the US 10-year yield.
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