The spike in yields of late has sent shivers through stock markets, which recently reached all-time highs and whose valuations are seen as stretched. But this rise in yields, if contained, isn’t necessarily bad news for stocks. Rather, it suggests to us that the rotation into reflation-driven cyclical stocks may have legs.
The inflation influence
Global bond yields have been trending higher for some time, but the pace of their gains has accelerated recently with the U.S. 10-year Treasury powering through 1.5 percent, its highest level in a year, up from 0.5 percent last August. Meanwhile, the German 10-year Bund yield has moved from a March 2020 low of negative 0.85 percent up to negative 0.31 percent, while the UK 10-year Gilt, which touched a low of a mere 0.08 percent last July, has jumped to 0.76 percent of late.
In last week’s issue, we laid out how yields are being driven higher by rising inflation expectations as the global economy heads towards further reopening. WTI crude oil is a case in point: currently at more than $63 per barrel, it compares to an average price last year of $39.
The reopening of economies seems increasingly imminent to us. Recent vaccine data from Israel, where the rollout is most advanced, suggests vaccination lowers the transmission rate of COVID-19, fueling additional optimism for a faster, wider easing of restrictions.
Inflation expectations are also on the rise in the U.S. due to concerns there may be more fiscal stimulus in the pipeline than the economy needs. RBC Global Asset Management, Inc. Chief Economist Eric Lascelles thinks another relief package perhaps on the order of $1.5 trillion will ultimately pass, coming on top of the $900 billion stimulus delivered last December. Together, these two would amount to some 10 percent of GDP in additional stimulus among signs of the resilience of the U.S. economy in the face of the COVID-19 shock. Case in point, the ISM Manufacturing Purchasing Managers’ Index was at 58.7 in January, far above the average since 2000 of 52.7. More stimulus in the form of an infrastructure bill may also be possible this year, but would likely take time to filter through to the economy.
However, Fed Chair Jerome Powell suggested in his recent testimony to Congress that inflation fears may be overdone.
He pointed out that the pace of improvement in the labour market has slowed, as has that for the overall economy, while prices remain rather soft in the sectors most affected by the pandemic. In other words, the U.S. economy will likely remain below potential for some time even as it reopens.
Powell’s testimony, the Fed’s commitment to allowing inflation to overshoot its target, and the high level of government indebtedness persuade us that the rise in yields will be contained. As we pointed out last week, sharp rises in Treasury yields are typically followed by range-bound trends. We expect the U.S. 10-year Treasury yield to settle between 1.5 percent and two percent on a one-to-two-year horizon.
Higher yields not necessarily a problem for equities
Investors have been concerned that higher bond yields may threaten equity valuations, which are now in excess of long-term averages. After all, a share price reflects the present value of future cash flows, and if the discount rate increases, the value of future cash flows decreases.
In practice, however, that is not always the case. In fact, since the March 2020 lows, equities have gained on the days when bond yields were up and retreated when bond yields fell. That is because the market interpreted higher bond yields as a sign of improving economic growth prospects. In fact, similar behaviour has played out since 2000 (see table).
As long as yields hover around two percent and are up due to expectations of higher growth and inflation, we would expect this relationship to hold. After all, equity markets were strong prior to the pandemic when yields were at two percent—though admittedly, valuation levels were not as stretched as they are now with the S&P 500 trading at 22.1x the consensus forward earnings estimate versus a 10-year average of 16.1x. But it would be unusual for price-to-earnings ratios to contract meaningfully in the midst of an earnings growth cycle when central banks are still supportive. Moreover, according to RBC Capital Markets, LLC Head of U.S. Equity Strategy Lori Calvasina, just over half of the companies in the S&P 500 today have a dividend yield in excess of the 10-year Treasury yield, suggesting the search for yield should continue to underpin stocks.
More concerning would be a sharper rise in yields, one much beyond that two percent level. Calvasina finds that stocks often struggle when yields climb more than some 275 basis points. For such a move to be replicated today, the 10-year yield would need to reach 3.25 percent.
Likewise, an increase in yields brought on by concerns about Fed tapering, i.e., a reduction in the Fed’s bond-buying programme, could also upset the apple cart as it would highlight the risk of the economy being close to overheating. But tapering is not likely before next year, in our opinion.
Overall, we think developed equity markets can cohabitate with higher bond yields. In Calvasina’s view, volatility may increase and there could be more pressure on the shares of highly valued companies, particularly if such companies disappoint in some way (e.g., an earnings miss).
We believe the increase in yields will underpin the rotation into reflation-driven stocks, which started last November. In turn, defensive and secular growth stocks, which drove performance in 2020, may lag. As such, Tech stocks may become vulnerable to profit-taking (this would be in line with the sector leadership rotation observed around bond yield increases in previous cycles). In addition, the performance of the Health Care sector and certain areas of the Consumer Staples sector such as food producers may well be underwhelming going forward.
According to Calvasina, the Financials and Materials sectors show the greatest tendency to outperform when yields are rising, with their performance closely linked to shifts in inflation expectations. She notes that both sectors in the S&P 500 continue to look deeply undervalued.
With the rise in bond yields this year likely to be contained, we maintain our Overweight stance in global equities, as we expect to see modest gains over the course of 2021. In the current environment, the recent sector leadership rotation towards reflation-driven stocks looks set to continue.