The correlation between rising bond yields & equities: What should you do?
April 9 2021 - Research@stockal
U.S. markets have cheered President Joe Biden’s $1.9 trillion stimulus package, the subsequent $2.3 trillion infrastructure plan, along with the rapid pace of COVID-19 vaccinations. Portfolio managers have snapped up recovery plays like energy, financials, industrials and sectors known to be sensitive to the economy. At the same time, bond yields have firmed in the past couple of weeks as the expansion in the U.S. economy also brings about worries over higher inflation. Analysts at Goldman Sachs say these are still short of levels that pose a danger, although they do mark a shift in sectoral performance.
Before we proceed ahead in detail, here’s what’s in store for you in this report:
- Rising bond yields and what it means for equity investors?
- Sector-rotation into cyclicals (recovery plays) with stronger growth profiles which will see a comeback in 2021
Chasing value outside growth stocks
The U.S. bond yields continue to steepen, underscoring traders’ bets on strong economic growth amid a return of inflation (Exhibit 1). And, investors are betting more on value stocks, compared with growth, reversing a trend that has been ongoing for years. What does this mean for the technology sector, which has an attractive risk-reward? Will it dominate the market leadership as it did in the past few years?
If history is any guide, in the period after recessions, the market leadership typically broadens out and includes more recovery plays. And, this is exactly what we are seeing in the U.S. markets right now. Sectors like energy, industrials, financials and equal-weighted consumer discretionary are likely to continue their uptrend in the rest of 2021.
Exhibit 1: US Bond yields vs. US Equities
Data as on March 2021| Source: Investing.com
Cyclical sectors see a comeback post-pandemic
With stronger economic growth and firmer interest rates seen in 2021, investors have sold growth-oriented and technology names that were the predominant drivers behind last year’s rally. Cyclical sectors like energy, financials, basic materials, consumer discretionary and industrials are propelling the market’s gain in 2021 (Exhibit 2). One can make the most of this sectoral rotation by staying invested into them in the current uptrend.
Why have investors shifted their preferences?
- Gradual reopening of the U.S. economy following COVID-19 vaccinations
- Sharp rebound in aggregate consumer demand
- Spike in yields of sovereign government bonds
Exhibit 2: Top performing sectors of 2021 vs. Benchmark S&P 500
Data as of March 2021 | Source: Fidelity Research.com
‘Banking’ on current valuations after 2020 sell-off
Banking stocks have rallied in the first quarter of 2021 on the potential impact of more economic stimulus, a macro-economic recovery and the prospects of rising interest rates — which are all good news for banks’ net interest margins. Despite the strong start, , the financial sector is still one of the most undervalued. Many bank stocks are trading at less than 15 times forward earnings estimates even as earnings growth outlook improves. HSBC Holdings, Signature Bank (SBNY),U.S. Bancorp (USB), Bank of Nova Scotia (BNS), PNC Financial services Group (PNC) are all having strong ‘buy’ ratings by analysts at current levels apart from big banks like Wells Fargo (WFC) and Goldman Sachs (GS). In the ETF space, Vanguard Financials ETF has generated a year-to-date return of over 17% in 2021.
Investors could see a 15%-25% upside in energy stocks
As crude oil prices rise substantially, investors have warmed up to the energy stocks. The sector had plunged last year after a shock crash in oil prices and demand. However, it has been the top performer in the S&P 500 index in 2021 so far as investors turn to industries expected to benefit the most from the economic recovery. Most fund houses see a potential upside in energy stocks and ETFs this year and have added renowned names like Exxon Mobil Corp (XOM), Chevron Corp (CVX) into their portfolios for 2021. Among ETFs, investors can look at the SPDR Oil and Gas Exploration & Production ETF (XOP) which has given a year-to-date return of over 38% in 2021 and has more upside potential considering the rising crude oil prices.
Meanwhile, recovery plays like industrials and basic materials see a huge interest among investors right from the beginning of 2021 as the demand for these sectors have picked up momentum due to increased manufacturing and industrial activities. These sectors are highly sensitive to the changes in the economy and were impacted as the pandemic outbreak weighed on economic growth. Investors can look at stocks in the construction materials space, paper and packaging products and some of the large Industrial stocks like General Electric (GE)
International Paper Company (IP): The company is gaining on strong demand for corrugated packaging and e-commerce activities in the wake of the pandemic. The increased demand is driven by processed food, beverage, proteins, chemicals, paper tissues and towels. The company’s effort to reduce debt levels appears very encouraging. At the end of 2020, its total debt-to-capital ratio was 0.55, lower than the industry average of 0.80.
General Electric (GE): This American multinational conglomerate has gained over 23% and in the last three months. Most analysts and hedge funds believe in GE’s growth potential and maintain a ‘buy’ rating at current levels. The company also helped develop thousands of ventilators to aid coronavirus patients in 2020.
Exhibit 3: Performance of cyclical stocks (Jan-March 2021)
Data as on March 2021| Source: Finbox.com
Stocks are still a premium over Bonds
As benchmark 10-year U.S. Treasury yields hover near 1.6%-1.7%, a quick calculation shows equities still appear attractive. When you take the S&P 500 earnings into consideration, equity investors will earn $172 per share this year (based on 2021 earnings estimates as per Wells Fargo Investment institute’s forecasts). When this is divided by the S&P 500’s current value, it gives an earnings yield of 4.4%, much higher than the current bond yield levels
With tempting returns potential, market participants now look ahead to a hot start for many stocks that stand to benefit from the strong cyclical economic growth and pent-up demand from consumers. It is prudent that investors balance risk and reward among sectors in a post-pandemic world.
Our next report will focus on the consumer discretionary sector and notable industries like hotels, restaurants and leisure, which are coming back strongly in 2021 due to an easing in virus curbs .