Could Good Economic News Be Bad News for the Market?
All eyes were on interest rates last week, as the rise in government bond yields accelerated, unsettling both equity and fixed-income markets. Bond volatility spiked to the highest level since April of last year, spilling over to other asset classes. While still very low from a historical perspective, yields have marched steadily higher over the last two months due to the prospects of an economic boom, or a rapid V-shaped recovery with accelerating inflation materializing later in the year. Tepid demand at an auction for government bonds last week and technical factors, like the selling of Treasuries from holders of mortgage securities, added fuel to the fire, leading to further increases in rates.
In his semiannual testimony to Congress on Wednesday, Chair Powell said higher yields are "a statement of confidence" about the recovery. Could expectations for faster economic growth deepen the sell-off in government bonds, sending shockwaves to equities?
Fortunately, we believe that we are not at the point where good news for the economy is bad news for the market. Historically, this dynamic happens at the tail-end of multiyear expansions, as strong economic data change expectations for Fed policy. In these cases, unlike today, short-term rates tend to rise, and the yield curve (difference between short- and long-term bond yields) flattens in anticipation of more restrictive monetary policy to cool an overheating economy. Today the yield curve is steepening as growth is expected to take off, and the Fed won't stand in the way for the next couple of years, in our view. We offer the following takeaways about last week's spike in yields and the implications it has for various parts of the market.
- Rates are rising for the right reasons, but the speed of ascent is a headwind
- The outlook for growth has got rosier over the last couple of months, with a V-shaped recovery looking increasingly likely as pent-up demand is unleashed. President Biden’s $ 1.9 trillion stimulus package, if approved, will hit the economy just as vaccines are distributed and the economy reopens, supercharging economic growth. Because of that, GDP could grow in 2021 at the fastest pace in the last 35 years, exceeding 5% and supporting a rise in inflation and interest rates.
- Despite the potential for a rapid recovery, the economy is still digging out of a sharp recession. Even if the economy reclaims its 2019 peak level in the second half of the year, it likely won't exceed its pre-pandemic trend until sometime in 2022. Therefore, fears of overheating that would trigger a U-turn in Fed policy are premature, in our opinion.
- On the back of strong market gains last year, equity valuations are stretched and already discount a lot of positive news. Last week's sharp move higher in government-bond yields unsettled equities, as it narrowed the excess return investors expect to receive from investing in equities over risk-free government bonds, also known as equity risk premium. This spread remains positive in favor of equities, but currently sits near the lowest levels over the last 10 years.
- Positively, we believe valuations can start to normalize as corporate earnings recover. With 95% of the S&P 500 companies having already reported fourth-quarter earnings results, earnings have surprised to the upside and are now growing after three consecutive quarters of year-over-year declines. S&P 500 analyst estimates for 2021 have been revised higher by about 4% since the start of the year, which is the fourth-strongest pace in the last 25 years, following the years 2018, 2010 and 20041. We believe there is more room for positive surprises given the aggressive government spending and outlook for robust growth. As January's income and spending data revealed on Friday, personal income jumped 10% from the previous month, and even though consumer spending also picked up, the rise in income was enough to boost the personal savings rate up to 20.5% from 13.4%2. The elevated savings represent potential pent-up consumer demand, which can fuel growth and boost corporate revenue.
The graph depicts U.S. aggregate real personal income, which is higher than it was before the start of the pandemic as a result of multiple rounds of government income transfers.
- The market is challenging the Fed's patience, and the Fed could respond
- In a two-day congressional testimony last week, Fed Chair Powel reiterated that while the economy is showing continuing signs of rebounding, there was much work to do, and the Fed will be patient before even thinking about removing accommodation.
- The forceful rise in bond yields implies that investors were disappointed that Powell did not push back against higher yields, and that investors are pulling forward their expectations for policy normalization. We think that the Fed is likely to continue its bond-buying program this year at the current pace of $120 billion a month, which could be adjusted to target longer-term bonds if higher rates start to threaten financial conditions. At this point of the recovery policymakers will likely not want a rise in long-term bond yields, which affect mortgage rates and could cause borrowing costs for consumers and businesses to get out of hand.
- Therefore, we think that monetary policy will remain a tailwind for the markets, as interest-rate hikes are still several years away. After a decade of undershooting their inflation target, central banks will likely let the economies overheat instead of preemptively tightening policy, which comes with the risk of short-circuiting the recovery.
- Sector leadership rotation weighs on major indexes, yet portrays a positive outlook ahead
- Last week's sharp rise in yields was a catalyst for the shift in sector leadership to accelerate towards economically sensitive sectors that have lagged since the start of the pandemic. On the other end of it, technology shares were under pressure, with the Nasdaq experiencing a 7% pullback from highs, and with growth-style investments logging their worst month over value investments since 20002. High-growth technology stocks derive a lot of their value further into the future, and higher interest rates have started to weigh on valuations.
- At the same time, cyclical sectors that stand to benefit from the reopening of the economy have picked up pace, outperforming in lockstep with the rise in rates. For the month of February, the energy sector rose 24% and financials were 14% higher, while technology shares were up 1%. However, when evaluating performance over the last 12 months, the roles reverse. The February gains have only reversed last year's losses for energy stocks, and the February gains account for all of the 12-month return for financials. Within the same timeframe, technology shares are 41% higher2. We think that value and cyclical investments have more room to run if economic growth accelerates as we expect. This type of increased participation from cyclical sectors, compared with the narrow gains that drove major market indexes last year, has historically happened in the early and middle stages of the market cycle.
- The tech sector makes up 27% of the S&P 500, and because of its large weight, last week's pullback was a drag on domestic indexes1. While we think that a period of relative underperformance is likely, we wouldn’t be quick to write off the tech sector. The sector's dominant companies remain highly profitable and continue to grow at a fast pace, which is why we think the pressure from rising yields will likely be contained.
- Bonds fall as yields rise, but there are still good reasons to own fixed income
- While a 2.8% decline so far this year in total return for investment-grade corporate bonds might not sound like a lot for equity investors, this is the worst start of the year in 40 years, and the decline is about in line with some of the worst historical bond drawdowns over the last 20 years2. In the near term, the move lower in bonds appears stretched and could partly reverse if central banks verbally intervene or increase the pace of bond purchases (already the Reserve Bank of Australia, South Korea and ECB officials have moved in that direction). However, as the recovery progresses, we expect bond yields to move gradually higher, but remain low from a historical perspective, as monetary policy stays accommodative.
- The question then becomes, "Why own bonds, and how should they be positioned in an environment of rising rates?" Outside of the relatively steady stream of income that bonds provide, we believe that the negative relationship between bonds and stocks still exists. In the short term the two can move together, as was the case last week, but over the course of months bonds are the asset class with the most consistent historical track record of hedging the volatility in equities, and thus help to act as a portfolio stabilizer.
- Longer-duration bonds can provide relatively higher yields but also come with greater interest-rate risk, and they are impacted the most in a rising-rate environment. A multi-maturity approach to fixed income (bond laddering), by including short-, intermediate- and long-term bond maturities, can help prepare investors for different interest-rate regimes. Also, we think that, in an environment of tight credit spreads and low but rising rates, an appropriate allocation to corporate investment-grade and high-yield bonds can make sense. We believe U.S. investment-grade bonds offer an attractive investment opportunity relative to international bonds because they have a lower sensitivity to interest rates and can offer higher yields.
The bottom line: The spike in long-term bond yields could prove to be a catalyst for stocks to take a breather, but it is not a structural threat to the broader recovery, in our view. The outlook remains positive, supported by additional fiscal stimulus, continued central-bank liquidity, vaccine distribution, and positive corporate-earnings trends. Good news for the economy will likely continue to be good news for the markets for a while longer.
Angelo Kourkafas, CFA
Sources: 1. FactSet, 2. Bloomberg
Weekly market stats
|Dow Jones Industrial Average||30,932||-1.8%||1.1%|
|S&P 500 Index||3,811||-2.4%||1.5%|
|10-yr Treasury Yield||1.42%||0.1%||0.5%|
Source: FactSet, 02/26/2021. *4-day performance ending on Thursday. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.
The Week Ahead
Important economic data being released next week include the PMI composite, jobs data, and consumer credit levels.