With Rising Rates, Safety First
Last week saw the 10-year Treasury rise from 3.056% to 3.227% and stocks pulled back. The market’s recognition of the coming rate increases was long overdue. That 17 basis point increase in the 10-year was prompted by Wednesday’s ADP report of strong employment gains, comments by Fed Chairman Jay Powell, and Friday’s job market data. It looks like investors are finally catching up with reality: the robust economy is forcing interest rates higher and at a faster pace than many investors were previously prepared to accept. Now that the evidence is too stark to ignore, investors are repositioning portfolios—both in fixed income and in equities. Commentators have been citing the tendency for stock prices to fall when interest rates rise and this may be helping push investors toward “safer” alternatives. And that move to safety may give rise to a resurgence in value stocks after several quarters of underperformance.
The Federal Reserve has been preparing investors for the coming higher rates and we have indeed seen short-term rates climb. This amounts to an acceptance by the market that the Fed will carry through with its plans to raise the Federal Funds rate gradually this year and next. But the market remained cautious in building higher rate expectations much further into the future: the yield curve (the difference between rates for different maturities) had been flattening. Last week’s news was a wakeup call. Not only does the economy continue to appear robust—last week’s data pointing to further employment gains and modest wage growth—but also Fed Chairman Jay Powell’s remark that “we’re a long way from neutral at this point” likely moved long-term interest rate expectations materially higher. And the yield curve has steepened:
Chart Source: Bloomberg
ACM’s fixed income portfolio manager, Kevin Kelly, wrote recently about the risk to longer-dated bonds (duration risk) of such rate increases, and last week we saw confirmation of that risk as rising rates caused the Barclay’s Aggregate Bond Index (which has a 6-year duration) to trade off roughly 1%. We saw a repositioning in fixed income securities towards shorter-dated bonds as investors sought to reduce duration risk. We continue to keep our fixed income duration below 2 years in the fixed income portfolio.
Equity markets, too, saw adjustments as investors reacted to higher rates, but some of the reaction ran counter to the usual logic. The S&P 500 fell 1.3% for the week as investors adjusted to higher rate expectations. But when rates rise, banks tend to benefit, and yet bank stocks sold off. The need for rates to move higher may have spooked investors into thinking this expansion must come to an end as the Fed tightens rates. But this isn’t usually the case: recessions come along for mostly other reasons (such as a spike in oil prices) and today’s economy is showing signs of continued expansion, rather than contraction. And utilities—one segment which usually suffers headwinds when rates rise—actually rose 1.9% last week. So we appear to be seeing a flight to safety. Technology sold off more than other segments, and the tech-heavy Nasdaq was down twice as much as the S&P. Value stocks outperformed growth stocks by 2% last week, and the MSCI Value Index saw its largest one-day outperformance versus growth since May 2009.
The main reason lower equity valuations follow from higher interest rates is simple: higher rates reduce the present value of future earnings and cash flows and so reduce the (present) value of a company. Companies with high price-to-earnings ratios are particularly vulnerable in a rising rate environment since investors own those companies for their future earnings potential rather than current profits. So when rates are rising, it may be time to find companies with the ability to deliver earnings sooner rather than later. And that means it may finally be time for value stocks to outperform growth stocks.
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