How to navigate higher rates and market rotations
How to navigate higher rates and market rotations
We’ve seen some turbulence in markets lately. Some of last year’s winners – including high growth stocks such as Tesla – experienced sharp falls in February while some of last year’s losers – like energy and banking shares – were up strongly. At the same time, the US 10-year bond yield has been rising pretty steadily with yields now at around 1.6%.
The move in yields is an important focus for markets. The change reflects what the market thinks about the current economic outlook, and it has an impact on various asset classes.
What’s behind rising bond yields?
The US 10-year yield hit an all-time low in March 2020 as the severity of the Covid-19 pandemic became clear. It continued around low levels for much of the year, but there was a move up in November as good news on vaccines was announced.
This year, yields have continued to move higher. This is not only because of the vaccines being distributed but also because of the fiscal stimulus announced by governments. The stimulus is partly aimed at patching up some of the economic gaps left by the pandemic – such as furlough payments to workers in shuttered industries – but also at promoting economic recovery.
The EU and the US are both undertaking significant stimulus. Indeed, in recent days we have seen Congress approve President Biden’s $1.9 trillion stimulus plan.
Hopes that we have a way out of the pandemic, and stimulus to boost future growth, are helping to lift asset prices. Oil moved up by $10 per barrel in February, from $52 to $62 per barrel. Strength in forward-looking data points, such as the purchasing managers’ indices, is also boosting growth and producer price inflation expectations.
We can see therefore that there are lots of catalysts to support a steepening of the yield curve (i.e. a rise in longer-dated bond yields vs near-dated yields), and expectations of higher inflation. Loose monetary policy, extraordinarily large fiscal spending plans, and real price moves in hard assets like oil all speak to a more inflationary environment. This has lifted expectations of future bond yields and led to rotations in the equity market.
What’s the impact of rising yields on stock markets?
The rise in yields may put a cap on the overall equity market for the time being while the market digests this step-change in the discount rate. A higher discount rate means earnings in the future are worth less than those produced in the near term when discounted back in today’s money.
As a result, the move up in yields, and therefore in the discount rate, particularly affects long-duration assets as well as growth assets. Long-duration assets are those that are expected to deliver a higher proportion of cashflows in the distant future. At the same time, it has provided a boost for shorter-dated, more inflation-orientated assets. This means we are seeing a rotation in the market towards more volatile (high beta) and cyclical sectors at a time that overall progress of the market has paused.
For markets to move on from here, we will need to see the very strong GDP growth expectations filter through to corporate earnings and earnings upgrades. That’s the big issue for the second half of this year.
In the meantime, as investors we need to be able to exploit the current rotation.
How is the rotation playing out?
My role is to run a multi-strategy portfolio largely made up of in-house Schroders equity strategies. That leaves me uniquely placed to assess not only how the rotation is unfolding across markets, but also how our in-house equity portfolio managers are responding to it.
Some factor rotations, such as the outperformance of value compared to momentum for example, have already moved strongly and may pause for now. But I’d expect such moves to resume as data points come through in support of the thesis of a V-shaped economic recovery.
It’s been interesting to track the shifts in style of our underlying portfolio managers over the past year, not just during this recent period of rotation.
Prior to the pandemic, the managers’ highest conviction around their fresh ideas was tilted towards the prevailing economic regime. That regime changed with the onset of the pandemic and the disruption of February and March 2020.
April to June saw managers kick the tyres of their existing holdings, meet with management teams and really understand how this pandemic was affecting these businesses. As a result, certain “style-agnostic” strategies became more defensive and orientated towards technology stocks, which were the big winners of the pandemic. Semiconductor stocks were particularly sought after while financials were shunned given that the prospect of economic recovery and higher yields seemed very distant.
After the summer, managers’ fresh investments became more “style-agnostic” once more. But from November onwards there has been a considerable shift in the tilt of new ideas, most notably with financials garnering interest again. This points to managers generally being pragmatic and adjusting swiftly to a changing market and taking a more pro-cyclical view with regard to the medium term outlook.
Right now, with the sharp rotation that we’ve seen, there may be opportunities to fish for ideas back in the growth parts of market. At an individual stock level, there may well be some examples of quality/growth companies that are now more attractively rated than they have been for some time.
Strong recovery potential for UK
Turning to country considerations, the UK is an area that lagged last year but now may offer recovery potential. The UK economy suffered severely from Covid-19 and the necessary lockdowns because it is highly skewed to social industries. It is therefore not surprising that the UK economy fell more than Germany in Q2 2020 (UK GDP fell -19.8% quarter-on-quarter, compared to -10.1% for Germany).
Coming into 2021, the UK went into stricter lockdown than the rest of Europe. However, there is now a clear plan to remove restrictions. The plan gives visibility, meaning that people can make investment, purchasing and travel decisions in the medium term. This should help the UK economy have a strong second half of 2021, with the recovery continuing into 2022.
For investors, that makes the UK an attractive country from an earnings revision point of view. We think the stock market is particularly interesting as a value/reflation play because the market has a high weighting to banks, miners, energy and other basic resources.
Looking longer term, the UK has to deal with impediments such as weak productivity and its low proportion of technology companies. The market is largely split between defensives (consumer staples, pharmaceuticals) on one side and pro-cyclical, pro-inflation sectors on the other. What it lacks is the middle tranche of dynamic tech and industrial leaders that you find in the Nordics and Germany.
That said, the UK appears to be in a better place from an investment standpoint than it has been for some time. We see it as an attractive recovery play and are particularly keen on UK small & mid cap stocks where there are some really interesting growth possibilities.
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