Global Economy & Markets Weekly Roundup 23/02/21
Rising interest rates set off alarms in the US equity market amid elevated P/E multiples
Key Takeaways
Most US equity market benchmark indices are at (or near) all-time highs. The recent acceleration in the move to higher nominal Government bond yields, has brought questions regarding the risk to US equities from higher interest rates.
Since the US Elections (November 3rd), US 10-Year Treasury nominal yields have increased by 44 bps to 1.34% due to higher growth and inflation expectations amid supportive fiscal policy and positive medical developments. At the same time, the Federal Reserve's flexible average inflation targeting framework, reinforces the low-for-longer interest rate policy.
Since the US Elections, breakeven inflation interest rates, albeit stalling lately, have increased by 42 bps to 2.16%, suggesting that market participants expect inflation to average circa 2.10-2.20% in the next ten years. Real interest rates, as obtained by Treasury Inflation-Protected Securities, which measure the returns which investors can expect once inflation is considered, have remained broadly flat, at -0.82% (+2 bps).
This constructive setting came under question in the past week, as the S&P500 recorded five consecutive negative sessions. The abrupt move higher in market-implied real interest rates by 20 basis points, as, inter alia, market participants brought forward their expectations regarding the first interest rate increase by the Fed (2022) weighed, in light of elevated equity valuations.
Equities' response to higher real interest rates, depends significantly on the underlying driver of the increase, and particularly on the extent to which it is "growth-driven" as opposed to "monetary policy-driven." If growth expectations remain firm, the impact on US equities is likely to be positive, even if the market experiences temporary nervousness.
On the other hand, positive shifts in real interest rates driven by expectations of more hawkish monetary policy by the Federal Reserve, as occurred within the 2013 "taper tantrum" by then-Chair Bernanke or Chair Powell's comments that interest rates were a "long way" from neutral in 2018, are negative for the S&P500.
A Fed tapering of its large-scale asset purchases is not likely this year, though additional communication by Fed speakers in that direction, could shift investors' perception. In that context, attention will shift to Chair Powell's semi-annual testimony to the Congress (23 and 24 February). Realized inflation surprising to the upside in the course of 2021 (>2.5% on a sustained basis), could test the Fed's tolerance of low interest rates.
For US equities, based on data retrieved from Professor Shiller's database since 1929, the strongest annualized monthly returns, tend to occur when inflation is below 1% but rises (+22% in real terms versus an unconditional average of +13%), which is often associated with a recovery from a recession and the diminishing risk of deflation. In contrast, when inflation is above 3% and rising, both US equities (-3%) and 10-year Government bonds (-5%) underperform, a "double-edge sword" for multi-asset portfolios.
Moreover, in the current environment, rising bond yields from extremely low levels, could be positive for equities as long as they reflect higher economic growth feeding through to strong corporate earnings revision momentum. If momentum falters, equity inflows ($172 billion Year-to-Date or 2.5% of ETFs and Long-only mutual funds AUMs) could stall too.
Regarding sectors, the biggest beneficiaries from rising US nominal 10-year Treasury yields, are Cyclicals names such as Banks, Energy and Autos, which exhibit a strong positive correlation with rising interest rates. On the other hand, large-dividend payers such as Consumer Staples and Utilities, exhibit a sustained negative relationship with interest rates.