How higher bond yields are impacting equity portfolios

0:11Hello and welcome to the latest FT Advisor podcast. This edition focuses on the outlook for equities in uncertain times. And joining me to discuss the topic are James Thomson, who runs the Rathbones Global Opportunities Fund. Ian Lance, who runs, among other mandates, the RWC Global Intrinsic Value Fund, and Mark Prescott, a portfolio manager at Morningstar Wealth. Ian, if we come to you first for the first question, and I suppose as a value equity manager this probably resonates particularly, but how do higher bond yields impact the way you think about constructing an equity allocation? We don't really change the way that we invest because of changes in bond yields.

0:55I suppose the way that we would think about it is we have to remind ourselves that 2010 to 2020 was a pretty unusual period for interest rates and bond yields, interest rates going to zero and negative in some cases. And that has some pretty large distorting effects on the market. So obviously, it was a great 10 years for bonds. It was a great 10 years for bond proxies in the equity market. And it was a great 10 years for long duration stocks, so growth stocks in particular. Not such great decade for value. Now, of course, what's happened in the last five years is we've normalized. So we've gone back to a more normal interest rate environment.

1:28And of course, that has been a much better environment for value stocks. So the environment is better for us at the moment. And I know that you've had allocations to banks a lot over the years. Well, generally speaking, they've gone up. Is that changing how you think about banks? But secondly, do higher interest rates change how you think about banks? Yeah, you're right. We had a big allocation to banks, not so much now. And part of the reason, well, there are two reasons for that. Number one is three or four years ago, they're exceptionally lowly valued. But coming back to the issue of interest rates, obviously, zero interest rates was bad for them.

2:05As interest rates normalized, net interest margins went up and it helped their profitability. At the same time, the loan losses were virtually zero. So you had this fantastic combination of very cheap stocks with fundamentals going in the right direction. um that we we would argue that to a certain extent that is now played out valuations are higher than they were not expensive and obviously the conditions have have normalized thank you mark i am as a as a fund buyer and an allocator to to equities but also other assets how do you how do you think about all of that when bond yields are are going up yeah i mean i think there's three points i'd make firstly um you know you need to sort of understand why bond yields are rising and there's clearly an inflation impulse there.

2:49There's questions about risk premium attached to certain sovereigns because of debt levels being higher. I think more importantly, though, for an asset allocator is the fact that bonds are now positively correlated to equities and they have been for a while. So that causes difficulties when building a multi-asset blend. Bonds and equities are the bedrocks of any NPS portfolio. and thirdly more positively bond yields are higher so over the long term you'd expect the yield to maturity to be achieved so it is making us think about allocations to bonds versus equities in aggregate and the weight there.

3:31Thank you and within the equity exposure does it change the type of equity funds or equities that you that you want to allocate to or i mean on the margin i mean the bank the bank points well made i mean we're valuation driven investors as well so we're you know looking at cash flow looking at the fundamentals of the of the equities and the indices that we buy and so um treat the equity market really as a sort of uh in isolation for the lion's share and consider things like long-duration assets clearly has an impact on higher yielding markets like utilities but you know generally we're thinking about the cash flows that each index is providing.

4:19Thank you. James if Ian is I suppose known as a value equity investor you're known for many years as a growth investor and how do higher bond yields impact a growth, a global growth strategy? You know, I think these higher yields are a good prompt for clients to think harder about the breadth and concentration of their portfolios. And I think it makes stock selection substantially more important because fewer companies can generate enough earnings improvement to clear the rising hurdle. And maybe without cheap financing, will the AI rollout come under pressure? You know, this has been a market that's been AI all the way.

5:01the only game in town. Maybe this is the talisman for a change in market leadership. We've already started to see a rotation. Some of the AI stocks that have been over-earning have no resilience or IP protection, who are vulnerable to a normalization period, have tanked. I'm looking at you, South Korean memory. Look, remember Zoom and Peloton during the pandemic? Those stocks have dropped 80 to 90 percent from their peaks as their growth normalized. I'm no AI naysayer, but you need to have balance, quality, and resilience in an equity portfolio. We're growing, but we're slowing. In 2026, it was beta and value did best as we accelerate from the start line.

5:45Next, I think as economic and earnings momentum peaks, investors will be more discerning and quality factors will begin to shine. Thank you. And James, one of the things that I found curious is interest rates going up. Obviously, it affects long duration bonds and it has done and that's what we've seen. But shouldn't it also affect long duration equities, including hypothetically, you know, tech stocks or AI stocks that will earn the bulk of their returns in the future. But that didn't seem to happen to the same extent. It happened in 22, but it didn't happen this year. Is that something that somebody such as yourself who has a material weighting to those types of stocks and to U.S.

6:28equities in particular has to be mindful of? Yes, I think that correlation has broken down. I mean, in fact, a lot of those long-duration quality growth businesses have already taken a lot of pain as the AI story has really crowded them out of the room. So, some of those long-duration plays have been a source of funds for the AI super cycle story. And as now yields move higher, I think that's been a trigger for investors to get back into some of those companies where cash flows may have a lower discounted rate today. But that's already been baked into the market. Thank you. So, James, if we stick with you for the next question, how relevant – I mean, you're on a global equity strategy.

7:17How relevant is the geographical location of a company? Do some stocks, in your mind, trade at a genuine discount simply based on where they are listed? I do think it requires an extra level of skill and expertise to invest in companies listed in emerging markets. I've spent a lot of time in emerging markets, and I've always returned feeling that I was at an informational disadvantage. It just wasn't always a level playing field. So if you're waiting for that valuation gap to narrow, I think you're going to be waiting a long time. The structure of many emerging market indices means that they should trade at a lower valuation.

7:57These are highly cyclical, economically sensitive stocks without the resilience or repeatability. so you don't get the same valuation as the nailed-on growth at Costco, Walmart, or Microsoft. So if you don't think geographical location matters, then you might have been tempted to invest in the Russian equity market a few years ago on a giveaway multiple of five times forward earnings. Then it dropped 50 % and now trades on two and a half times earnings. So where was the margin of safety? So I don't invest in emerging markets directly. I think it requires someone who can analyze a different set of variables.

8:35But I do back developed market companies that sell into or source from emerging markets because these people have the skills and the boots on the ground knowledge to navigate some of those exciting markets. Look at Coca-Cola. In emerging markets, 70 % of drinks consumed are not commercial beverages. They're locally sourced beverages, teas, unbranded juices. This represents 80 % of the world's population. And so as income per capita grows, more commercial beverages are consumed, you get supernormal growth coming from those markets. So I think this is a huge advantage to invest in companies that have emerging markets exposure from developed market listed businesses.

9:16Thank you. And Mark, when you're putting together an equity allocation, do you think geographically at any point, you know, we want an overweight to this region versus that region? Is that how it's done or is it different for you? Yeah, I mean, practically speaking, we look at two lenses really, sort of the country regional breakdown. And partly that's driven by history, by availability of funds, availability of active and passive managed funds. But you're right that there is less homogeneity around with country funds, you know, and there's that they, you know, each country has its own characteristic based on history of listings, etc.

10:05So we've increasingly focused our attention on sector, looking at going down into industry, grouping into industry, and we're seeing a growing suite of products available to really pick a granular exposure. And we try and build capital market assumptions down to sort of geeks level three now. Although often some of the industries are two or three stocks, but sometimes they are actually quite diversified. And I think it beggars the problem with countries is how concentrated they become in certain, even emerging market index now is sort of 40, 50 percent, three stocks, very much linked to the AI build out.

10:49US as well. The UK is a classic, very narrow index. So that's fine if you know what you're owning, but it does, I think we're finding it easier now to sort of think more broadly at a sector and industry level alongside the country analysis. Thank you. Ian, some equity markets are, I suppose, associated with being value markets. It's a point often made by UK equity managers. If you want diversification, you own loads of the growth stuff in the US, but you own UK for value or you own US for growth if you want to diversify from value. But is that how you think about it with your global hat on? Because I know you're in UK Mandates as well.

11:29Yeah, exactly. But is that how you think about it? Or just as a value manager, are there certain markets where you're always going to find more opportunities? No, I don't think so. I don't think some markets are always going to be cheap. What we try to do from a global perspective is make sure that we have a reasonably diversified geographic allocation, but only where we can buy value. And today, actually, that's relatively easy because lots of international markets look very cheap, particularly compared to the US. One thing we won't do is the US is over 70 % of the world index today. We would never even think about having that amount of money in one country.

12:10That just doesn't feel like sensible diversification to us the final point i'll make on this on this sort of valuation normally if you look at something like the uk actually it is interest the uk has traded at about 20 discount to the us um on average over the last 50 years or so um but in the last couple of years it got down to nearly 50 discounts of the us so it was very cheap and people used to say well that's fine but you know what's going to be the catalyst to realize that value well all of a sudden we've got I think most people know, takeovers left, right and centre. In the UK, other companies just coming in and buying up UK companies and UK companies themselves buying back their own stocks.

12:51All of a sudden, you have got these catalysts that are realising that undervaluation. And do you think the discount in the UK has been because the companies happen to be listed in the UK, as in people are looking at the UK bit and saying, oh, I don't want that, Or is there something wrong with many of the companies in the UK or the composition of the UK? No, it's very definite. It's the former. It's this unfortunate fact that, you know, when I started off in my career, the average UK pension fund would have over 50 % of UK equities. And today it's got anything. It's got sort of 2 % or 3%. So there's just been this structural selling of UK equities over the last 30 years or so.

13:28And that's been replicated across, you know, the big wealth managers who tend to look at the benchmark. and as the UK has gone down, they've been selling the UK as well. So you've just had this structural selling of the UK, but what you've ended up with is actually companies that are fundamentally decent companies trading at a significant valuation discount to their international peers, which we regard as an opportunity. Thank you. Mark, what lessons from how equity markets have performed in the past decade can we take into the coming years, if any? um it's a weighty question uh quite philosophical i mean i for me i would you know have to talk about the rise in passive investing it is distorting markets um and momentum as a factor appears to have more and more power and you know there's a linkage there that i you know academically i've not, I'm sure a paper has been written on it, but I think that there is a linkage there.

14:32That weight of passive, it's trickier for active managers. The narrowness of markets is also one that is potentially at breaking point with the AI cycle right now. We'd hope so, but there is still potentially legs in the theme, just given corporate behavior that we're seeing a layoffs and investment in AI alongside that. So I think the point about the changing in the bond yield environment is right and relevant. The cost of capital is higher and more normal. So, but, you know, history repeats and rhymes. And, you know, for us, we have a process that seems to work through various parts of the cycle in the focus on fundamentals, aware of valuations.

15:30And so for that respect, not much is changing for us. Thank you. Ian, from your point of view, I mean, you touched on it earlier. We had a long period of growth doing well and now a period of not quite as long, but we're getting there of value doing well. But what lessons can you take or have you taken from the past decade? Yeah, I think the lesson is that nothing goes on forever and eventually valuation matters. And we've seen this before, haven't we? So in the late 60s, we had the nifty 50 bubble. And following that, believe it or not, the US market underperformed for 20 years from 70 through to 90.

16:13Then we had the same thing during TMT, where the valuations got extremely stretched. and then 2000 to 2010, the US underformed very significantly. And I think we're seeing something similar today. Valuations of a lot of these types of stocks went up a lot from 2010 to 2020. A big component of their returns were driven by re-rating during that period. And eventually you get to the stage where the ratings are so high that re-rating just cannot go on when your free cash flow yield has gone from A to 1. and eventually that becomes finite. And of course what happens is eventually it probably goes back in the opposite direction and that's what we've seen.

16:53So I think that's my big lesson is that for a period of time you get this suspension of people looking at fundamentals and valuation but in the long run ultimately it does matter. Thank you. And James, from your point of view you've seen not just the last decade but dare I say it, maybe the one before that one. The one before that, right? I've certainly known you a good few years What lessons can we take from the last decade and spring forward for the future? Yes, 23 years managing global equity money. And I think my takeaway, the lesson has been that returns are going to be more inconsistent.

17:32So many investors seem to be following the same trends. So you're getting different factors and styles in the market that are running red hot and others ice cold. And I think the shift to passive does mean that that volatility can be amplified. Such a large part of daily trading is now linked to baskets and mechanical trading. And as investors kind of move in and out, the market concentration is going to drive bigger moves. 10 % of stocks are now 40%. That's 10 stocks are now 40 % of the S &P 500. And when the herd wants to move out of equities, those supersized weightings are going to be painful for investors.

18:14But on a positive note, there's different problems to face, but I'm always impressed with the adaptability and the resilience of our businesses. Economic growth may slow, but I think the pace of change only gets quicker. Thank you. Ian, you referenced earlier, eventually valuation does matter. One of the things that has been a feature of markets this year, I guess, has been that despite all of the macro noise, despite all of the concern about valuation, corporate earnings have in general been quite strong. Earnings growth, I mean, has been quite strong. It's been quite strong both in the narrow range of tech stocks, but also more broadly.

19:01But can that continue? I mean, to some extent, it feels like corporate earnings are defying gravity. Does gravity come in and matter eventually just as valuations do? Yeah, no, it has been extraordinary. I think the forecast for S &P earnings this year is north of 20%, that sort of figure, which is extraordinary. Normally, you only get that coming out of a recession. You don't get that after you've gone through a strong period of economic growth. But it's important to look at the two things that have driven that. So I think the two things that have driven it are AI CapEx and the other thing is the US government running a deficit of 6 or 7 % of GDP.

19:38Now, to my mind, neither of those two things are sustainable. I cannot see AI CapEx continuing over a trillion a year. And I cannot see the US government being able to run a deficit of that size without there eventually being some sort of reckoning, whether that's bond yields or the dollar or whatever. So to my mind, those things will not go on forever and eventually that will impact on corporate earnings. Thank you. James, from your point of view, I mean, the broadening out story has been, I guess, much commented on this year. And a lot of that is the AI CapEx is influencing some energy stocks.

20:22It's influencing some real estate stocks. It's influencing maybe some construction stocks. So it has been spread out, but can it continue? And what is the market pricing in? Is the market pricing in another 20 % next year? We're about to get some very real-world data points. I think we're going to see blockbuster earnings growth and upgrades to forecast this third quarter earnings season. And the real question in my mind is, will investors look through higher rates and the potential for re-escalation in Iran following the midterm elections? Can they look through that and maintain that momentum?

21:01A significant amount of the growth has come from AI CapEx. Some analysts think that 50 % of the S &P 500 are AI-related stocks. And the industry is now planning for something like 200 gigawatts of AI capacity. In data center footprint, that's about 10 ,000 football fields. I love this new measure of economic activity. How many football fields it is? Yes, I used AI to come up with that statistic. Perhaps not in England's green and pleasant land. But, you know, the hyperscalers themselves can fund about half of that. But the other half needs to come from outside capital. And I think it's increasingly clear that that's getting harder to find.

21:43So durability now matters. And I think the winning portfolio should increasingly combine durable earnings revisions with valuation discipline rather than just relying on multiple expansion. Thank you. Mark, from your point of view, the earnings growth has been there. but is it something that you're, when you're thinking about that balance between bonds and equities and anything else, do you have a feeling that maybe, you know, this is as good as it gets on the equity side and therefore other asset classes maybe deserve some time in the sun? Yeah, I mean, I think over the years I've realized how tricky it is to call, you know, to bet against equities.

22:26So, you know, the point about bond yields being higher, but, you know, equity earnings have been incredibly strong. And if you look at multiples of some of the AI names, there is a margin of safety attached to it. The Korean tech stocks, memory stocks are trading on very low multiples. And there's a sense of suspicion that the market is placing on some of those earnings about the durability of them. And so I don't think it's, you know, the market hasn't got, you know, extremely carried away where we're seeing, you know, forward earnings that are, you know north of 50 which we saw back in the dot-com days so there is there is an element of circumspection there that that said it's difficult to to to really get behind them with so much uncertainty and the the numbers the you know trillion plus capex it's it's difficult to see that um being repeated so we're sort of sitting a little bit behind behind underweight this subset and trying to build diversification into the portfolios.

23:35What's been fascinating is the fact that oil prices, we've seen oil prices north of 100, and typically that's a headwind for economic activity. And so in a way, you could argue equities are defying gravity in that respect. And what worries us is if there is a de-escalation of tensions in the Middle East and we see oil prices normalising, that could catalyse another wave of these AI names doing very well. The earnings are there and the market seems to like them. So it's balancing the underweight really. And what we're looking at, I mean, there are pockets of, so indices themselves are quite concentrated, but there are pockets of valuation anomalies so consumer stocks have been left behind you could ask whether property property names are looking quite attractive and so we're trying to sort of um squeeze in some some valuation anomalies in the consumer without really um betting the house on it based on what we're seeing in terms of what the earnings are doing so thank you and then as a as a as a final uh Question.

24:48I'll ask the equity guys first and then Mark. James, is there a particularly cheap area, whether that sector or country, within equity markets right now in your view? I'm always suspicious of outright cheap stocks. Usually there's some gremlins. So not cheap, but I do think many consumer stocks are undervalued, hit by rising rates, high gas prices, the cost of living squeeze. But remember that those conditions may not last forever and tough comparisons start to ease next year. And they're also outside of the AI enablers trade that has captured all the love of the market. But many of these companies have much more durable growth than investors appreciate today.

25:33And as AI moves from the enablers to the adopters, I think this could provide a new line of top line growth and margin potential for these companies. Let me give you one example of Walmart, 11 ,000 stores,$150 billion in annual GMV. But I think one of the most advanced adopters of AI that I've seen in my portfolio, Wally, it's their internal AI agent for merchandising teams. It acts as a self-healing inventory system. So instead of waiting for a store to run out of an item, the AI actively scans external indicators like social media trends or delivery disruptions and shelf stock levels, and it autonomously redirects stock replenishment.

26:22So there'll be no sad American children this Christmas. Or how about Sparky? Sparky is your personal AI shopper on the Walmart app. This is conversational commerce. No more typing. More than 50 % of customers are using this rather than traditional text search. So you tell Sparky that you want to fill up your basket with your normal weekly shop, and it fills the entire basket. And it's a really sort of high-margin advertising event for Walmart also because it can cut down the number of choices that it's offering to you by running a silent auction in the background. What's this doing for Walmart?

27:01It's driving a 40 % increase in their basket size. And then they'll deliver to you on average within 42 minutes. So this is a huge uplift for this business. I mean, I just booked my Ocado Christmas delivery slot. And yet Walmart can get it to you in America for under an hour. Thank you. Ian, as a value investor, I'm sure you always think there are loads of good value stocks out there. but maybe two years ago, three years ago, if we were having this conversation, you would have replied by saying banks. We touched on earlier, you don't necessarily see banks in that universe. Now, what are the new banks?

27:42Yeah, so, I mean, this even surprises me that I'm about to say this, the largest sector in our portfolio today is consumer staples. Because a lot of the consumer staples names that used to trade on sort of 20 or 30 times earnings, you can now buy today on 11 or 12 times earnings. So that has been a massive difference. The other area that I was going to mention is what we call AI losers. So the market sometimes can be quite simplistic. It basically says, you know, one group of stocks are the AI winners, and it puts on them on sort of stratospherically high valuations. And then it does the opposite.

28:15So it says, right, another group of stocks are the AI losers, and they're put on very, very low valuations. Now, some of them might be, but a lot of them probably won't be. And what this means is that you can buy things like, an example would be Accenture. So, you know, leading global IT services business. That got down onto a single-digit PE recently. So you're getting the opportunity to buy what we think are some pretty good businesses at very, very low valuations. And the final thing that I will mention about them is that they have a really interesting diversification angle, by which I mean on days in which the AI troddy is blowing up, so a lot of the big AI stocks are falling.

28:54a lot of those companies will be up four or five percent on the day so you can sort of see this rotation going on within the market of people selling down ai stocks and and buying the i suppose the the offsetting stocks thank you and um mark obviously you don't have to like equity so there may not be any cheap ones to your mind but but is there is there a particular opportunity set that you're that you're interested in yeah i think it's fair to say we're seeing dispersion has narrowed. So, you know, when we sort of assess it at an index level, but the consumer stories are music to my ears because, you know, we are, you know, using global managers to access these stocks.

29:34We have ETFs in those portfolios that we can. So, world staples or European staples, and we sort of broadened out the world staples into a European staples position, the likes of Nestle. So it's been, that's an area that we like. We do like emerging markets. We've got a position in Brazil, which we believe is, you know, diversifying, it's giving us some exposure to energy. There's risks attached to the positions and election. Markets hate elections. But, you know, that's definitely an area where we see sort of trough valuations and it's a position, sort of an alpha position or opportunistic position.

30:17But generally speaking, we've been narrowing our bets. So we've been taking profits from healthcare, which we had a position in. We've been taking profits from Korea and Asia and EM. So we've been shrinking our bets a little bit, but we're index investors. And so we do see a lot of opportunity at the stock level. So the index is masking this dispersion at the stock level, partly because of the concentration. So we've seen some real winners and losers from the AI trade. And on the margin, thinking about active management more to take advantage of these anomalies. But that said, the momentum behind the AI cycle is still there.

31:01So doing it with some circumspection. Thank you for that, Mark. Much food for thought there from all of our contributors, but that is all we have time for. And thank you to our guests. And thank you all for listening.

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