The 10-Year Treasury Yield is arguably the most quoted proxy for market interest rates. At the beginning of the year, the yield stood at 0.9%. It is around 1.6% as of this writing and recently climbed above its pre-pandemic levels. While still low by historical measures, the recent move higher has been sharp and notable in percentage terms. For reference, the all-time high in yields was over 15.5% in the early ‘80’s, while an all-time low of 0.6% was reached just last year. Nevertheless, the recent move higher has sparked a significant rotation within asset classes and ignited a debate regarding its ramifications.
Bond math can be complicated, so for simplicity sake we are just going to focus on levels. And, more importantly, the reasons behind those levels. The pace and duration of interest rate moves are the most significant considerations for capital markets. Too fast, and asset prices turn volatile as they need time to adjust. Too prolonged, and valuations suffer while secular winners turn into secular losers. While short in duration (roughly three months), the recent move higher in yields was the fastest pace in almost fifty years.
Bond prices carry an inverse relationship with yields. As those yields move higher, bond prices move down (and vice versa). But it’s not just bond prices that are affected. Any asset that has a future profit stream that needs to be discounted back to present value will have a lower value if higher rates are utilized in the calculation. The stock market has grown accustomed to lower interest rates (and higher values), so any change in the mechanics always raises a few eyebrows (ala the “Taper Tantrum” of 2013).
Importantly, we believe yields are rising but for the right reasons – higher expected inflation and growth – which historically has not been a headwind for the capital markets. That said the rate move is causing significant changes in relative performance across sectors, industries and asset classes. And for this reason, we are spending a lot of time reviewing the interest rate sensitivity of our positioning. We believe rates gradually increase this year, but the associated risks remain contained.
For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities. Since the beginning of the pandemic we stated that the retrenchment in economic activity, while necessary, is self-inflicted, not structural, and prone to snapping back as re-opening resumes or vaccines enter the narrative (see The Road Back, Resilient, or Delusional?, Escape Velocity, Navigating the K-Shaped Recovery, Election Vexation, Back To Basics, Inoculating The Unprecedented, New Year, New Leadership? and Gamestop. Bubble Trouble, or Storm In a Teacup? here). We are seeing that snapback happening now with economic forecasts increasing significantly. We see the move higher in rates as a symptom of that working narrative.
We wrote last month that despite the volatility, the promise of economic normalization could lead to pronounced sector and industry rotation. We noted that investors are continuing to discount what a backdrop may look like six-to-twelve months from now and expressed confidence a vaccine can take us from pandemic to panacea, towards normalcy and away from some of the uncertainty. We see no reason to change that view.
February more than reversed January’s losses, with most markets posting impressive returns (e.g. the S&P 500 was +2.6%, the Russell 2000 was +6.1%). Former laggards continued to pick up relative strength (e.g. materials, financials, economically sensitive groups like energy, etc.) as the recovery broadened. The rise in rates added fuel to the rotation as many recovering groups (e.g. banks) benefitted from the steepening yield curve. We continue to see ample room for these rotations within the market to continue, but don’t want to completely fade secular growth stocks that have been recently under pressure. We believe there is room for both.
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macro analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends, influenced by our recessionary and bear market views, are increasingly painting a more optimistic picture (positive).
The current macro discussion starts with an understanding of vaccination trends (and thus the reopening). Forecasts show new cases/infections dropping to 50% by early April 2021 and then falling to near zero by May 2021, suggesting that ‘herd immunity’ will be essentially attained much quicker than expected. Coupled with the recent passing of a new $1.9 trillion stimulus bill, this all but guarantees a robust rebound in economic growth in 2021. We believe US GDP growth will be the best in forty years in 2021.
The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low interest rates, a series of government support packages and a commitment by the Fed to highly accommodative policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. They will continue to be tailwinds well into 2021. The Fed is anchoring short-term interest rates and has expressed unequivocal accommodation, despite longer-term rates sniffing out a recovery and pushing higher. We will need to monitor any change here, but so far, the rate backup hasn’t altered the Fed’s stance.
Inflation expectations have increased as signs of a global economic recovery increase. Inflation has been relatively non-existent since the Global Financial Crisis (arguably for 40 years) and is worth watching in 2021. Many macro indicators are adjusting (e.g. the yield curve steepened further to the widest level in three years, TIPS inflation readings broke out to seven-year high, Brent oil touched $63, etc.), but we feel broad measures of inflation look contained. At these levels, we welcome any narrative shift from deflation to inflation.
The current technical backdrop remains in decent shape. We wrote last month that several short-term metrics we monitor were a bit stretched (e.g. put-call ratios were low, the percentage of stocks trading above key moving averages were high, etc.). Encouragingly, market breadth is expanding, and the highly concentrated market of 2020 continues to ease. Small-cap stocks are outperforming large-cap stocks by a wide amount so far this year. A broad market is a healthier market, so we welcome this development.
We still don’t think investor sentiment is euphoric. We sense healthy skepticism, with the recent consolidation helping to burn off some excessive optimism. There are still trillions of dollars in money market funds and, despite the advance, flows into equities are far below those of bonds and cash. We feel pullbacks present opportunities to deploy capital for the long-term.
Fundamentally, we are focusing on the trend in corporate profits and. credit metrics. Earnings estimates continue to be revised higher and we suspect 2021 will end with profit levels at record highs. Valuations are stretched in some pockets of the market, but only slightly above long-term averages in others. Valuation dispersion is at record levels with a big gap between the secular growers and more economically sensitive recovery plays. During the recent rotation, it has been the cyclicals that have benefited most. We expect that trend to continue, albeit with less dispersion.
The credit backdrop has improved with both investment-grade and high-yield spreads vs. Treasuries back to pre-pandemic levels. Because continued tightening here is consistent with a rally in stocks, it has been encouraging to see. Dividend reinstatements (or increases) are now running well ahead of dividend cuts. As corporations’ confidence in their outlook continue to improve, we expect share buybacks to follow.
In sum, we are comfortable with the recent move higher in interest rates. We believe it is happening for “good” reasons, and don’t see any systemic risks at this juncture. The move has strengthened our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to de-stabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments.