Revisiting Short-Duration Stocks
Although central banks may be near the end of the rate hike cycle, short-duration stocks may still be an attractive investment theme should interest rates remain at higher levels.
A key theme we have supported over the past year is that higher "quality" stocks are likely to outperform the overall market. In April of last year, we wrote about one way we define quality: short duration. Specifically, we stated that short-duration stocks might outperform and act as a hedge against rising rates in a volatile market. Over the past 12 months, short-duration stocks have outpaced the overall market by seven percentage points and acted as a hedge against the losses in the overall market by holding their value.
Short-duration stocks have outperformed consistently until March
Source: Charles Schwab, FactSet data as of 4/1/2023.
Low price to cash flow = bottom 20% of stocks ranked by price to cash flow in MSCI World Index. Performance relative to MSCI World Index. Past performance is no guarantee of future returns.
While the performance has been largely consistent, short-duration stocks did not outperform in March. Have short-duration stocks started to underperform now that central banks appear close to the end of their rate hike cycles? We don't think so, but we will explore the support and risks for short-duration stocks going forward.
Short duration defined
What are short-duration stocks? Duration is the average time until cash flows are received, weighted by their present values. In other words, stocks with more immediate cash flows have a shorter duration than those that are expected to deliver a higher proportion of cash flows in the more distant future. To measure duration for stocks we used the price-to-cashflow ratio, the lower the ratio, the shorter the duration. We define short-duration stocks in our charts as the lowest 20% of stocks in the MSCI World Index ranked by price-to-cashflow.
Since interest rates began to climb in August 2020, investors have favored companies with stronger near-term cashflows. This was the opposite of the investing cycle of 2009-2020 when companies with little to no earnings or cashflow were the among the best performers, due to abundant low-cost funding.
Now that interest rates may be at or near a peak, will investors once again favor companies more dependent upon borrowing to fuel their growth over those that are better able to fund themselves? The answer may depend on how quickly and substantially interest rates fall from here. There are two potentially different outcomes:
- Should interest rates take a dive in response to a deeper global recession where central banks are forced to cut rates aggressively back toward zero, we may return to an environment of cheap capital that could power outperformance of long-duration stocks.
- Alternatively, if central banks merely stop hiking and hold rates steady (or cut marginally) at relatively elevated levels, then short-duration stocks may resume their outperformance.
Short-duration stocks outperformed in March with the exception of 10 days when banking troubles hit markets, fueling uncertainty as to the direction of the global economy and central bank activity. While the extent of the fallout on lending from the bank stress is still unknown, central bank officials in the U.S. have expressed no concern that the collapse of Silicon Valley Bank and Signature Bank would lead to broader systemic risk. With the help of the Swiss Central Bank, the long-troubled Credit Suisse was rescued by UBS. In the absence of additional financial instability, central banks might not engage in rapid and aggressive rate cuts later this year as inflation remains well above target levels. Since March 17, short-duration stocks were back to outperforming the overall market.
Central bank outlook
Some central banks seem to be going on a spring break. The Reserve Bank of Australia (RBA) took a break from hiking rates in April, following the lead of the Bank of Canada in March. But the RBA statement left the door open for more hikes (as did the Bank of Canada) noting they expect that some further tightening of monetary policy may well be needed to ensure that inflation returns to target as they take more time to assess the state of the economy. It isn't unprecedented for central banks to take a break only to return to hikes. Norway announced a break in January and February only to have to commenced hiking by 25 basis points (bps) in March.
The net number of central banks hiking rates has been trending lower (as you can see in the chart below), but no major central banks have supported an outlook for rate cuts this year. However, the futures market has priced in about 75 bps of rate cuts by the end of the year for the U.S., 50 bps for Canada, and 25 bps for Australia. If the market moves to price in even more rate cuts, short-duration stocks could lag.
Past the peak but not entering a valley
Source: Charles Schwab, Bloomberg data as of 4/4/2023.
Based on study of 76 central banks.
Comparing the markets view of the Bank of Canada's policy rate for December relative to the current policy rate helps us to understand changes in perception about the path of rate hikes as depicted in the chart below. Futures market expectations went from anticipating one more 25 bp hike in early March to nearly 100 bps of cuts during the bank stress of mid-March but has since eased, rather than continuing to deepen. This pattern is repeated in the futures market's outlook for the U.S. Federal Reserve and RBA.
Market rapidly reconsidered year-end policy rates during March
Source: Charles Schwab, Bloomberg data as of 4/4/2023.
Not just rates
It isn't just the rate outlook favoring short duration stocks in the current environment. These companies, with their higher cash assets, tend to have relatively strong balance sheets, solid interest coverage ratios and low default risk. That helps to make them attractive during periods when access to capital becomes more difficult and earnings growth is shrinking.
The global outlook remains uncertain–while growth and inflation are likely to moderate in coming months, how fast and how far is unknown, Historically, after spiking higher, inflation has eased in wave like patterns–easing and rising again. Markets could remain volatile if inflation follows this wave pattern, which could result in higher-quality, short-duration stocks outperforming.