Investors worry that the Fed’s swift leadership means it will have to hit the brakes


Here are two things that are true: a stronger economy is generally good for stocks, and a stronger economy means higher yields on Treasuries. Logic students don’t have to make much progress in their studies to realize that therefore higher Treasury yields are not necessarily good for stocks, and if they missed the class they need nothing more than to throw in a look at last week’s markets.

Last week, bond yields rose and stocks fell. The problem was that yields rose for reasons other than economic optimism, and stocks didn’t like it. Federal Reserve Chairman Jerome Powell used his testimony before Congress on Tuesday and Wednesday to calm the market, but an unusual spike in yields on Thursday brought stocks down.

When yields go up because the economy improves, it shouldn’t hurt stocks (the size of big tech raises some questions this time, but save that for later). Yes, higher returns reduce the value of companies’ long-term earnings, but a stronger economy means more of those earnings in the first place.

When yields rise because bondholders are scared off by the size of Treasury auctions, or when bullish momentum takes over, or when investors fear a shift in focus from the Fed, there is no improvement. compensatory economic to help stocks.

What happened last week appears to be a growing concern that the Fed will keep its foot on the gas for too long and will have to hit the economic brake hard in the future to control inflation.

Earlier this month, Eurodollar futures prices for the Fed to raise rates from the current range of 0% -0.25% to 1.5% -1.75% by 2025, and investors were on agree with that. This month, the market has started to raise rate prices by another half a percentage point by then, even as rates for the next two years are expected to remain unchanged (as the Fed itself says).

Ingrained inflation expectations in the Treasury bond market for the next five years have risen sharply this month, even as expectations for the next five years have fallen. It may seem strange to worry about what will happen to inflation many years from now, given that investors have no hope of even predicting what will happen next year, but the general outline suggests growing concern that the Fed is taking it too long. calmly. It is true that the Fed can get high inflation back in check more easily than it can push low inflation. But if inflation rises too high, you may have to hit the economy hard to get prices back under control, and the combination of rising rates and a weaker economy is definitely bad for stocks.

We can be more granular about the impact on stocks than simply talking about the market in general, because the divide between Big Tech and cheap economically sensitive cyclical companies is so extreme, and because the two sides of the market react so differently to Treasury yields and the economy.

Big tech and similar growth companies are not very sensitive to the state of the economy, but they are sensitive to changes in bond yields. Cyclical stocks are very sensitive to the state of the economy, but they are not greatly affected by Treasuries. And in both cases, both are more sensitive than in the past.

We can measure this very simply by comparing Nasdaq stocks, which tend to be growth oriented, to the S&P 500, which includes many more cyclical stocks from the old line.

The link between rising Treasury yields and the outperformance of the S&P is the strongest since at least 1980, with daily changes in yields accounting for more than half of the relative performance. Typically, changes in returns have little influence on relative performance.

We should see this as a good thing. Just as Big Tech and the Nasdaq did very well even when the economy crashed, they should underperform or even crash completely as the economy recovers. Exactly this has happened to the FANGs since the beginning of September. Facebook Inc.,

Apple Inc.

and Netflix Inc.

—As well as Amazon.com Inc.,

which are often added to the acronym, have since gone down, even as their expected earnings were updated. Alphabet Inc.,

Maiden Google, the fourth of the quartet, has risen.

Cyclicals offer more short-term growth, while the promise of distant future equity growth is rendered less valuable by higher bond yields.

The market is also broader. Through Sept. 1, the S&P 500 was up 9% even as more than half of its members fell, because it was the largest stocks that rose the most. The stocks that outperformed the market during the period have an average market value of $ 120 billion, while the stocks that have outperformed the market since then (about two-thirds of the index, again showing the spread) are worth less than half .

There are two new dangers. First, bond yields could rise further, with no additional force on the economy to offset. Second, market leadership could have shifted from cyclical stocks to speculative stocks, an unlikely combination of electric vehicles, clean energy, cannabis, and bitcoin that finds its nexus in Tesla. Inc.

Chief Elon Musk and ARK Investment CEO Cathie Wood. If the speculative excess ends badly, the slide could drag out much of the rest of the market.

Write to James Mackintosh at [email protected]

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