It is often said that smart money resides in bond land. With the total value of bonds outstanding being 3X that of equities, there may be some truth to this mantra simply due to size. Historically, interest rates move well in advance of stocks, but one does not exist without the other. After seeing interest rates basically collapse during one of the most bullish economic periods we have ever seen, questions are going to arise and rightly so.
Interest rates rise with a growing economy which makes economic sense. When companies see more demand for their products, they are apt to apply for loans and expand operations. An increase in request for debt shifts the equation in favor of lenders and increases their ability to raise rates on loans. Basic supply/demand. Ever since it became apparent that we would get past this Covid shutdown due to an explosion in vaccines, interest rates reverted back to their historical range, rallying to 1.7% in March on the critical 10-year Treasury. Recall that over the prior decade that yields ranged from 1.4% – 3.2%. Many expected recent solid growth data to last even longer and that rates would get back to 2% over the rest of this year. We are now below even the low-end of our old range. Something is amiss!
Take your pick on what is reversing this bond trade:
• The stronger Delta variant is now a dominant strain across the globe. More and more countries are shutting down, yet again. The Olympics will have no fans in the stadiums. Israel Covid data analysis yields a declining efficacy of vaccines, pointing to booster shots being the next logistical nightmare. It likely also means Covid is more of an endemic, similar to the flu. Global investors are becoming more fearful, but when a Japanese 10-year government bond yields 0.03% and German Bund is a negative 0.33%, international investor cash will flow to the States causing our rates to decline as well. Getting ~1.3% is much better than nothing, or losing money in many countries.
• Fed tapering is not here yet, but it is coming. Simple math will tell you when the Fed stops buying bonds, additional buyers have to replace that or interest rates rise. There is no question Quantitative Easing helped lower interest rates. The opposite should also be true. However, yields also rise due to growth and inflation. Pulling the QE punch bowl could slow growth down and we’re already seeing inflation peak. Bond investors are getting ahead of the curve here and are more fearful of slowing growth and inflation than they are worried about less buying from the Fed.
• Growth is certainly going to slow on its own. You can only reopen the economy once, so the comparisons next year to today’s numbers will be much more difficult to beat by such wide margins. If/when stimulus slows, it will be even more difficult. Valuations are at extremes and need double digit EPS growth to sustain their pricing. That becomes more of a question mark towards the end of 2022 when things normalize. Sellers of stocks will park money in bond land, causing interest rates to decline further.
• Money flow is a powerful force. Recall the old trading range of 1.4% – 3.2% for 10-year Treasuries. That lasted for nearly a decade. Breaking out of that range brings additional sellers/buyers in either direction. Now that we’re below old support levels, additional sellers come to the fore, exasperating the decline. 90%+ of economists were calling for rates to be above 2% by year-end. Now that it seems less likely, short covering ensues as well.
Whatever the reasoning (and it’s likely a combination of all listed along with a few others), we’re left with questions on what to do next. Lower rates have been helping growth stocks resume a leadership role relative to the value/cyclical trade. Pick any growth company, Facebook#, Apple#, Amazon# or Microsoft#; their growth is hardly reliant upon a specific yield curve. The shift to cloud services, 5G, online shopping and digital advertising is coming no matter what. They are leaders in either scenario. However, lower rates continue to allow elevated P/E levels, so this should be a long-term positive.
Yesterday’s stock market action was the first real bout of broad-based fear where every sector was down in price. The Dow Jones opened down over 500 points but rallied, somewhat, to close down 260, which is only 0.75%. Cyclicals led the decline yet again as Financials and Industrials were relative laggards. Financials, banks in particular, are tied to the yield curve. This 25%+ drop in interest rates has brought a 10% – 25% drop in many banks since May. It may be time to start nibbling on some of your favorites in these sectors as rates “should” improve from here with solid economic and employment data ahead. Global hiccups will happen, but many countries, especially in Europe, have yet to get the reopening bounce. They will play catchup to the U.S.
Companies with predictable earnings in software, consumer staples and pharmaceuticals held up better than most on Thursday. Again, a drop in interest rates has no real effect on demand for software, food, toothpaste, soda or the need for medicine. Mini-corrections like this, where some sectors are able to provide the expected “defense”, are constructive, especially when compared to last year’s liquidation phase where even the safest stocks got crushed.
As with most bull markets that have massive moves like a 16% S&P year-to-date advance or a near doubling in just 16 months, any hiccup will bring selling pressure. 5% corrections are “supposed” to happen 2-3 times a year. Who knows if this is the start of something that large, but long term everything still looks fine. This mini cleansing phase will bring about more opportunities to reposition portfolios, rather than run for the exits.
What would become a real concern is if major economies have to fully shut down again. This is a stretch at the moment, but short-term fear is here for now. Delta variant fears will crimp the reopening phase and point to somewhat slower growth than initially hoped for, albeit still driving in the right direction. However, if this forces more countries to shut down (especially in emerging markets where vaccines aren’t readily available), supply chains will suffer, international travel restrictions could be extended into 2022 and many consumers will be reluctant to expand their circle of trust. Even with vaccines, many are still concerned about this deadly disease. Anything that makes them more cautious is obviously not good for growth. Again, this is only a few months of slowing. Eventually vaccines will be readily available worldwide and we’ll get past closures for good.
That does not mean we completely reverse course or dip into a recession. A fractional drop in GDP is not going to crush earnings. Rather, we may have gotten a little bit ahead of ourselves, pricing in too much optimism. Shaking that tree and digesting massive gains is perfectly normal and to be expected. That being said, interest rates should stabilize around current levels which would reverse the recent growth over value trade initially. Further drops in rates could cause even more concern that something is truly wrong on a global basis. That fear is for another day, if at all.
Legendary actor Tom Hanks is 65 today. Penny stock fraudster, Jordan Belfort of The Wolf of Wall Street fame, turns 59.
James Vogt, 610-260-2214