The most recent run up in US Treasury yields (the 10-year benchmark bond yield peaked at 3.03% on 25 April 2018, though it had fallen back to 2.94% by 4 May), and the lacklustre performance of US equities, have renewed worries about the outlook for the stock market in face of higher financing costs. Many investors are worried that with price-to-earnings and price-to-sales multiples still at elevated levels, they could see multiple compression even if earnings growth remains good (the price-to-next-twelve month earnings ratio on S&P 500 is around 16.8x and price-to-sales around 2.1x, both well above long-run averages).
The performance of the stock this year, as yields have swung between 2.4% and 3.0%, has differed depending upon the sectors and their sensitivity to interest rates. It is illustrative to separate the market into three parts: 1) Tech + (which removes the Internet Retail & Marketing sub-industry from Consumer Discretionary and adds it to Information Technology), 2) the “bond proxies” (Consumer Staples, Health Care, Telecom Services, Utilities, and Real Estate), those sectors that have benefited most over the life of QE by offering relatively high dividend yields relative to fixed income, and have conversely suffered as rates have slowly normalised, and 3) Cyclical “minus” (Energy, Materials, Industrials, Consumer Discretionary excluding Internet Retail & Marketing, and Financials). The weights of the three groupings are 30%, 28%, and 42% respectively of the S&P 500.
While there have certainly been other factors driving equity index returns recently (notably the threat of a trade war with America taking on the rest of the world), the pattern of returns gives us some clues to how the market may evolve from here. We separate the time since 24 January into three periods: “Rising rates 1”, from 24 January to 21 February when the 10-year yield rose 29 bp to 2.94%; “Falling rates”, the subsequent period to 2 April 2018 when rates dropped 21 bp to 2.73%, and finally “Rising rates 2”, the following period through to 25 April 2018 when rates moved up again by 30 bps, peaking at 3.0% (see Figure 1).
Figure 1: S&P 500 absolute total returns and relative sector returns for three US interest rate moves*
Data as at 4 May 2018. Note: Absolute total return for the S&P 500, relative returns for the sector groupings. *Rising rates 1, 24 January to 21 February 2018. Falling rates, 21 February 2018 to 2 April 2018. Rising rates 2, from 2 April 2018 to 25 April 2018. Sources: FactSet, BNP Paribas Asset Management.
The first thing to note is that, despite the perception that equities have been struggling, the market actually gained 2.3% in the third period when rates were rising in contrast to a loss of 4.6% in the first period. The bond proxies performed as one would expect, underperforming the market in both periods of rising rates and outperforming when rates declined. The component sector returns, however, have been more varied. All five sectors had negative total returns during Rising rates 1, while during Rising rates 2, Health Care, Telecom Services, and Utilities have posted positive returns, driven partly by robust M&A activity.
The performance of the cyclical sectors has not been correlated with interest rates, as one would expect, underperforming whether rates were rising or falling in the first two episodes, while outperforming more recently. The difference is likely because the latest episode of rising rates has occurred during what has been a very strong earnings season. Though positive earnings surprises have resulted in little relative outperformance for the stocks concerned, the good overall earnings gains (over 20% year-on-year, admittedly a figure enhanced this quarter by tax cuts), has not gone entirely unnoticed.
The sector with the most volatile performance has been technology, which has been hit by the threat of more regulation globally, more taxes in Europe, and a disruption to both its sales and its supply chains if the trade dispute between China and the US escalates. While prices have consequently suffered, there is little apparent impact on analysts’ earnings estimates, as revisions continue to outpace those for the rest of the market (see Figure 2). The most obvious change has been in valuations, which have fallen since prices have suffered while earnings revisions march upward. We continue to see most of the long-term positive drivers for the sector as intact (see the article in the last edition of The Intelligence Report, “De-fanged? Threats to the tech sector from Trump and regulation”). If trade tensions do not result in tariffs on companies in the tech sector, this earnings trend should ultimately benefit stock prices.
Figure 2: Next-twelve-month earnings estimates revisions
Data as at 4 May 2018. Sources: FactSet, BNP Paribas Asset Management.
The driver of performance for the bond proxies will continue to be US interest rates. We do not anticipate, however, that rates will rise significantly through the rest of the year. We expect the yield for 10-year Treasuries will end up between 3% and 3.25%. Several factors support further increases in rates: rising inflation, additional hikes in the Fed funds rate, and the concurrent running off of the Fed’s balance sheet. These factors, however, will be offset by sustained tensions with China and Europe over trade, even if an actual trade war is avoided. This suggests the bond proxies will lag the rest of the market, but not necessarily generate negative returns. This drag from higher rates, however, will probably hurt the performance of US equities relative to other developed markets (where interest rates are not rising), given that these sectors represent 28% of the S&P 500 market cap.
The outlook for the Cyclical “minus” sectors we believe is still positive, as economic growth in the US remains strong, consumer sentiment is buoyant, and corporations are using funds from tax cuts to increase business investment, reduce leverage, raise dividends, and/or boost buybacks. While valuations are indeed above average, we do not believe this will be a key determinant of market movements in the medium term, until, that is, the US economy is much closer to a recession than it is today.
The final reason to believe that the market can withstand a slowly rising interest rate environment is that historically there is little correlation between the change in interest rates and stock market prices when the economy is expanding (Figure 3).
Figure 3: US equities and changes in bond yields
One month change
Data as at 16 February 2018. Data weekly from 1999 except real yields from 2003. Sources: Bloomberg Barclays, Federal Reserve Bank of New York, BNP Paribas Asset Management.
This typical explanation for the low correlation is that there are offsetting impacts from higher rates. On the one hand, higher rates mean higher financing costs for companies, while on the other hand if rates are rising because growth is strong (and not rising to reduce inflation), which is the case today, then economic growth should mean greater corporate profits. One should not forget the experience of 1994; Fed funds rose by 250 bp and 10-year Treasury yields by 200 bp, but the S&P 500 still posted (modest) positive gains for the year. We anticipate much smaller moves in rates over the next 12 months.
Equity markets often shudder when rates move up quickly, and interest rate sectors in particular suffer, but interest rates are not likely to continue to rise at the recent pace and we believe they will end the year at a level not significantly higher than they are today. With most other drivers of stock market prices supportive, investors should not lose faith.