Rising yields = the tipping point

I continue to believe that rising real long bond yields mean we have seen the peak in growth stock vs. value stock outperformance and the chances of a genuine growth stock correction are increasing by the day. This is a major market development and one that shouldn’t be ignored. It is time to take profits in high flying, expensive growth stocks, expensive small caps, and expensive defensives, and either rotate to value or move to the sidelines and hold some cash.

Below I am going to quote directly from an equity strategy note titled “The Tipping Point” by Morgan Stanley’s Chief US Equity Strategist Mike Wilson as I think it’s an excellent and succinct summary of where we are at.

The Tipping Point

Morgan Stanley & Co. LLC Michael Wilson Equity Strategist | Chief US Equity Strategist and  CIO of Morgan Stanley Wealth Management and Institutional Securities

“September bucked the normal seasonal pattern, proving to be a fairly calm month for financial markets.  Global equities even started to broaden out a bit with international stocks doing better, led by Japan.  Credit markets also displayed resilience with one of their better months this year, despite the fact that the rates market was suffering one of its worst.  The presumption was that global growth was improving and could be more sustainable than markets had feared.

As we entered October, the move in rates continued, with the 10-year Treasury yield making new highs last week in dramatic fashion.  We’ve often found that it’s not the magnitude of the rate move that matters most for financial markets, but its speed.  Last week’s surge checks both boxes—it was big and fast!

Perhaps Japan’s newfound leadership in September was an early warning that this rate move was coming.  After all, Japanese equities would stand to be the biggest beneficiary of rising global inflation and interest rates, accompanied by a stronger US dollar. Emerging Markets, on the other hand, don’t fare as well under this scenario and have been a laggard in September and so far in October.  

Since July, we have been recommending that investors fade the areas of relative strength in global equity markets—US small caps, Tech, and Consumer Discretionary shares—in favour of some of the laggards like Japan, Europe, Energy, Industrials, and Financials.  In short, we’ve been recommending value over growth on a global basis.  Over the past 10 years, growth stocks have absolutely trounced value stocks worldwide.  In the era of below-trend GDP growth and negative real interest rates, it was logical for investors to favour a barbell of steady income and growth stocks. Therefore, early in the recovery from the financial crisis, this led to extraordinary performance in bonds and income, producing stocks known as the “dividend aristocrats.” Growth stocks also enjoyed most-favoured-nation status.

However, as interest rates began to rise from their secular lows in summer 2016, bonds and the dividend aristocrats started losing their lustre, while growth stocks continued to attract capital and re-rate even higher.  I think this disconnect made sense when rates were still very low.  Bonds and bond proxies are sensitive to moves higher in interest rates from any level, while growth stocks remain immune until rates cross a certain threshold.  Was that level breached last week?  We think the answer is yes, because growth stocks now are less attractive while many discarded value stocks, like financials, become more appealing.  It’s notable that last Thursday the MSCI World Value Index had its  greatest one-day outperformance relative to MSCI World Growth since May 2009.

In our US Equity Strategy research, we highlighted in September that the S&P 500, as a whole, had become overvalued for the first time since January, based on our Equity Risk Premium framework. This overvaluation was apparent as yields on the 10-year broke through the 3% barrier. Small caps had already been underperforming for several months, but as rates moved above 3%, their underperformance accelerated.  With last week’s surge toward 3.20%, weakness finally came to the high-flying growth stocks where valuation is the most stretched.

Given their lack of dividends and high valuations, high-flying growth stocks are arguably the longest-duration assets in the world.  Therefore, it’s perfectly reasonable that they would eventually succumb to rising rates.  We just didn’t know at what level it would happen.  Much as in January, when a sudden move higher in the 10-year yield led to a rapid and broad 12% correction in US equity valuations, we see a similar risk for the smaller cadre of stocks and assets that have maintained their valuations since the January highs or moved higher.  

This was precisely our call back in July when we downgraded US small caps and Tech stocks.  At the time, we thought the valuation gap would close as the sustainability of growth was called into question.  However, the break higher in interest rates last week appears to be the tipping point, enabling the rolling bear market to complete its unfinished business in these last bastions of safety.

With the recent 10-year Treasury move, the S&P is now overvalued for the first time since January “

As you know I have been cautious/bearish on long bonds for some time, feeling rising real rates were coming as inflation picked up and central banks ended QE. That is happening right now and the equity market at this moment in time remains too sanguine about it. I think that will change and I agree with Mike Wilsons view above. It is time to be cautious and disciplined.

Let’s run through some macro charts to remind us that this is a major event in world interest rates, but particularly the world’s “risk free rate”, the US 10 year Treasury Bond yield. This will also have clear ramifications for the global and local equity markets.

Leading indicators are pointing to higher inflation going forward, the chart below is one of the indicators we follow, published by the NY Fed. This forecast is supported by recent events such as Amazon increasing the minimum wage from $11 to $15/hr and strong commodity prices (particularly energy) feeding through to higher prices.

NY Fed Underlying Inflation Gauge Vs Core CPI (lagged 16 months)

The US 30 year treasury yield is responding….

Remember, after a decade of QE, central bank action is turning negative. Fed balance sheet redemptions will increase and ECB will cease purchases at the end of the year.

It’s also worth pointing out that T-bills now yield more than the equity market, so for the first time since the GFC, there is a genuine alternative.

T-Bills yield more than the equity market

What does this mean from an Australian equities perspective???

  1. The small cap bubble will burst
  2. Infrastructure stocks will fall
  3. Healthcare stocks will fall
  4. LICs at premiums to NTA will fall
  5. The ASX200 will fall as dividend yield becomes less attractive vs rising real bond yields
  6. You need more cash as the return on cash is rising