Rising yields drag stocks lower

CIO Daily Updates

by Chief Investment Office 19 Jan 2022 5 min read

Thought of the day

What happened?
The S&P 500 fell 1.8% and the tech-heavy Nasdaq 2.6% on Tuesday, as investors continued to adapt to a more hawkish stance from the Federal Reserve. Markets are now pricing in four rate rises this year, implying that the Fed will move swiftly to address elevated inflation.

The yield on 10-year Treasuries has this week moved above 1.8% for the first time since the start of the pandemic, reaching 1.89% in European trading on Wednesday. This has undermined growth stocks—including the tech sector—since the present value of future profits declines as rates rise.

The latest sell-off was accentuated by disappointment over results from the financial services sector, including lower-than-expected earnings from Goldman Sachs due to weaker trading activity. Overall, the sector fell 2.3% on the day, amid additional worries over intensifying wage pressures in some segments of the business. Energy was the only major sector to gain ground as oil prices continued to rise, with Brent crude now up 13% since the start of 2022.

On Wednesday, Asian markets traded lower, with Japan's Nikkei 225 index falling 2.8% and China's CSI 300 down 0.7%. In Europe, the Euro Stoxx 50 rose 0.2% in early trading.

How do we interpret this?
We have been braced for heightened volatility as markets digest signals from the Fed that tightening will come sooner than previously expected. But while we believe the Fed is likely to raise rates as early as March and three times overall in 2022, we don’t think this pace of increase alone will derail corporate profit growth or the equity rally.

Despite a mixed start to the fourth quarter earnings season, only around 7% of S&P 500 firms have so far reported, and we continue to expect robust results to shift attention away from worries over Fed policy and back to corporate fundamentals. Our estimate is for 4Q21 earnings to grow by close to 30% from 4Q20, seven percentage points better than consensus forecasts, reflecting a revival in economic activity and solid consumer spending.

At a sector level, we expect continued volatility in the technology sector, but the pressure on the sector from higher yields to abate in the months ahead. While we see 10-year yields climbing modestly higher, from 1.89% at present to around 2% by June and 2.1% by the end of the year, we do not expect a further sharp rise. We think the 2-year Treasury has moved too aggressively in pricing in Fed tightening, and we expect the yield curve to steepen.

It’s also worth keeping in mind that historically stocks have performed well in the months leading up to the Fed’s first rate hike. Since 1983, the S&P 500 has risen 5.3% on average in the three months ahead of the start of the rate hiking cycle and by a further 5.3% on average in the six months thereafter.

What should investors do?
While the increase in bond yields is challenging for both fixed income and equity investors, we continue to see opportunities:

  • Position for rising yields. We recommend reducing interest rate sensitivity in portfolios to combat the rise in yields. With 2-year yields already up around 32 basis points so far in 2022, we believe shorter duration segments of the curve have already priced in much of the Fed’s hikes into 2023, unlike 10-year Treasuries, where we see the yield headed to 2%. We therefore believe the shorter end of the curve, along with less rate-sensitive credit segments, will outperform longer-duration credit segments.
  • Seek unconventional sources of yield. In a world of rising yields and compressed spreads, we see limited opportunities in conventional fixed income asset classes. For yield, therefore, we advise investors to look beyond conventional fixed income markets. US senior loans offer an attractive 4.4% yield and are relatively insulated from rate rises by their floating-rate structure. For investors who are willing to lock up capital for longer, we like private credit, which we estimate can generate a yield between 400 and 600 basis points above benchmark rates for first-lien loans to middle-market companies. Within FX, we favor currencies that are exposed to more hawkish central bank policy (e.g., the USD and GBP), where yields are rising more quickly than elsewhere.
  • Diversify into the ABCs of tech. Although the NYSE FANG+ index of megacap tech firms lagged the broader US stock index last year, it has still outperformed since the COVID-19 low point for markets in March 2020, climbing 172% compared with the 106% rise for the S&P 500. We believe this presents an opportunity for investors with excessive exposure to megacaps to rebalance toward emerging opportunities in the tech sector. While we expect tech overall to face challenges in the months ahead from rising yields, we still see upside in 2022 and beyond from foundational technologies, notably artificial intelligence, big data, and cybersecurity—the ABCs of tech. As businesses and governments sharpen their focus on these three segments, we expect their combined revenues to grow from USD 386bn in 2020 to USD 625bn in 2025.
  • Stick with winners from global growth, balanced with defensive exposure. We expect economic growth to be strong as we enter 2022, favoring cyclical sectors like energy. But moderating growth over the course of the year could start to favor more defensive parts of the market. Recent volatility has also shown the importance of holding a diversified portfolio. We think the healthcare sector can play a valuable role in investor portfolios in the year ahead, providing defensive characteristics as well as exposure to attractive structural growth themes such as medical devices. Read more on opportunities in healthcare here.