One of the first things new scuba divers learn when training to dive is how quickly they can come back to the surface. If a diver comes up too quickly, bubbles of nitrogen are released into the bloodstream that can lead to decompression sickness, also known as “The Bends.” Stocks got a case of The Bends last week as rates rose too quickly for the market to absorb. This could easily happen again, to a more significant extent, if the Fed loses control of interest rates.
After another strong start to the year for stocks, last week brought a reminder of what volatility feels like. Several days of large moves in stocks caught most of the headlines, but the fireworks were truly felt in the bond market. The 10-year Treasury started the week yielding 1.37%, up from 0.93% on Jan 1st. On Thursday, a very poor 7-year bond auction spooked investors and the selling cascade began. At its highest level, the 10-year rate spiked to 1.61%, an increase of 0.24% over the course of just 4 days! While 0.24% is simply a rounding error in the equity markets, the move represented an increase of 17.5% and the volatility eventually flowed over into stocks, with the S&P 500 down 2.41%.
The beginning of the week brought a strong relief rally, but it couldn’t erase the question that is now being asked: “Are higher interest rates going to be a problem for stocks?” The answer to that question is yes and no.
The chart above shows the Real 10-Year Treasury Bond Yield going back to 2003. The Real Yield is an “inflation adjusted” yield that is simply the current Nominal 10-year Treasury Rate minus some measure of inflation. This chart has two inflation references, Personal Consumer Expenditures in blue and TIPS yields in red. The main takeaway from this chart is that going back to 2011, we have had 3 periods where Real Yields have been negative, including now. You also have two periods in late 2013 and late 2018 when Real Yields peaked around 1.5%. The first peak didn’t matter to stocks, but the second time was a different story, as the Fed reversed its attempt to raise rates for the first time in 10 years as the market dropped around 20%.
Why Do We Care?
What do Real Yields have to do with stocks? For starters, when Real Yields are negative, it naturally forces money into stocks and other risk assets, as the prospect of investing in a bond that will give you a guaranteed loss, after inflation, isn’t particularly appealing. This is where the investing acronym “TINA-There Is No Alternative” was born, implying the only place to get any return in such a low-rate environment was to invest in riskier assets.
But a market that has thrived on low rates, both Nominal and Real, over the past decade may naturally show some level of concern when that environment starts to change. The combination of fiscal/monetary stimulus, declining COVID cases, and now a third viable vaccine has set the stage for a more sustainable economic re-opening. With that comes expectations for economic growth that could spur demand that will eventually lead to inflation in a COVID-19 supply constrained economy. As inflation expectations move higher, rates are beginning to adjust accordingly.
With inflation expectations currently around 2 to 2.5%, rates have a lot higher to move just to get to a Real Yield of 0%. For some context, the 10-year Treasury yield was 1.92% on Dec 31st, 2019. The stock market can likely absorb a gradual, steady increase in interest rates as long as it is accompanied by strong economic growth.
Going forward, HCM expects rates to continue to drift higher unless the Fed decides to intervene and attempt to cap rates (Yield Curve Control) or the economic re-opening proves to be much weaker than expected. As long as the process is orderly, we aren’t terribly concerned that higher rates will cause major issues for stocks, although opportunistic volatility is to be expected. The sectors that we have focused much of our attention on recently (Value, Small Cap and International/Emerging Markets) should benefit from any increase in inflation and/or rates. In comparison, the market outperformers from last year, high PE Growth stocks, would most likely underperform. We have positioned portfolios accordingly and may look to add equity risk on market weakness. We have also continued to adjust our fixed income portfolios to lower duration and diversify exposure away from interest rates.
Weekly Focus – Think About It
“You have power over your mind, not outside events. Realize this and you will find strength.”
Performance last week for the four major asset classes were:
- U.S. Stocks – Russell 3000 (IWV) – Loss of -2.80%
- Developed Foreign Markets (EFA) – Loss of -2.94%
- Emerging Markets (EEM) – Loss of -6.61%
- Fixed Income (AGG) – Loss of -.043%
(Note: performance is based on the change in price plus dividends)
Last Week’s Headlines
- Sharp moves higher in government bond yields caused volatility in the equity markets, with several days of choppy trading as investors digested the move.
- Johnson and Johnson’s COVID-19 vaccine was approved for immediate distribution by the FDA and CDC, with an estimated 3-4 million doses set for circulation.
Eye on the Week Ahead
- Debate will continue on President Biden’s $1.9 trillion dollar stimulus package and if approved, should arrive alongside increased vaccine distribution.
- Bond Yields will remain in focus as Fed Chair Powell could provide updated guidance regarding Fed Policy and how they may handle rising rates.
If you have questions about the recent market conditions, please contact a member of HCM’s Wealth Advisory Team:
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- The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
- Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
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- Consult your financial professional before making any investment decisions.
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| Doug Johnson CFA
Doug is the Senior Investment Strategist in the Investment & Research Department. He guides the Investment Committee in developing and implementing HCM’s investment strategies. Doug and his wife Cindy live in West Chester with their two sons. In his free time, Doug enjoys family time, golf, playing and watching hockey, and travel.