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Good morning. It was an interesting reflection of the market’s mood that investors looked straight past Friday’s weak headline jobs number and focused instead on the low unemployment rate, with all its inflationary implications. Jittery times. Email us: [email protected] and [email protected]
Real rates up, tech stocks down. Maybe.
Rising interest rates are bad for tech stocks. I know this is true because I read it in the FT:
The tech-focused Nasdaq Composite shed 4.5 per cent in the first five trading days of 2022, the worst annual debut since fears of a slowdown in China sent shockwaves across global financial markets six years ago.
The tech tumble came as US government bond yields surged the most in 28 months, as concerns mounted that the Federal Reserve would need to raise rates more aggressively than was previously expected to tame hot inflation.
There is clearly something to the link between tech stocks and rates, but I suspect there is less to it than meets the eye. It is undoubtedly true that tech stocks — or, more broadly, growth stocks — have recently performed badly when rates rise. Here are 10-year Treasury yields over the past two years, plotted against the relative performance of the Russell value and growth indices:
The standard explanation for this, as is hammered into our poor little heads all the time now, is that higher rates mean a higher discount rate applied to future cash flows; so big cash flows far into the future are worth relatively less when rates rise; so growth stocks, which carry high expectations for distant cash flows, get hit harder. This is just math and is fine so far as it goes.
What was particularly striking about this week’s move in Treasury markets was that it was not driven by higher inflation expectations, but instead by a rise in real interest rates — as reflected, for example, in 5-year inflation-indexed Treasuries, which are the blue line in the chart below. They rose by a quarter of a percentage point, breaking out of the range they have been stuck in for more than a year:
The usual thing to say about real rates is that they are an indicator of growth expectations, and on this logic, one would argue that growth expectations went up this week. Indeed, the FT reported that some people are thinking this way:
Investors and strategists said the move in the $22tn US Treasury market signalled a growing comfort that the Omicron variant would not hamper the recovery. The 10-year US Treasury real yield, which strips out the effect of inflation on the debt, climbed to minus 0.97 per cent, its highest level since mid-December.
People also argue that growth in real yields, as opposed to nominal ones, is particularly bad news for tech, because of what it says about growth. Again, the argument is familiar: in a market where real growth is scarce, growth stocks command a premium. From an article in Bloomberg:
“If we do see real yields improve, it’s going to be a much more difficult environment for tech,” Christopher Harvey, head of equity strategy at Wells Fargo said. “Especially for ‘growth at any price’ stocks. The place where you should see this is your high, high growth and your high-multiple stocks.” .
“What struck me about yesterday’s sell-off that was so important was that the bulk of the price action occurred in real yields, not in break-evens,” BMO Capital Markets strategist Ian Lyngen said Tuesday on Bloomberg TV. “So this is a growth story and not an inflation one at this point.”
This basic story, while not outright false, is too simple and should be treated with caution. Here are some reasons for scepticism:
As I have noted before, the market for inflation-adjusted treasuries (Tips) is not nearly as liquid as the vanilla Treasuries market, and is as such more sensitive to Fed buying and, indeed, idiosyncratic supply/demand considerations. It might not contain loads of useful information.
It is a little odd, to put it delicately, to suggest that what happened last week was a sudden jump in growth expectations. The main news of the week was that the Fed is set to tighten monetary policy more aggressively than previously expected. This is supposed to cool the economy, no? Maybe all real rates are saying is “the Fed is tightening faster”.
If growth expectations really rose last week, one would expect credit spreads to have narrowed. They widened a touch.
As my frequent correspondent Edward Al-Hussainy of Columbia Threadneedle noted, the relationship between growth expectations and real rates is not terribly determinate over the long run. Real rates have been falling much faster than growth over the past several decades. Real rates just are not a straightforward indicator of growth expectations.
The link between growth stocks and real rates looks as much like self-fulfilling prophecy or herd behaviour as it does an expression of economic logic. People think it should work this way, and so trade accordingly. Herds change their minds, though.
Revisiting the S&P 10
We have been harping on about how the S&P 500’s great performance has been driven by what we call the S&P 10 — the biggest 10 stocks in the index. In December we presented this chart of how the S&P 10 have performed, compared with the S&P 490, and with stocks outside the US:
Note that the 490 are beating global equities. US stocks, while not as spectacular as the S&P 10, are still killing it. Alas, still emerging from holiday stupor, we got a bit sloppy in a letter last week when we wrote:
Globally, the US accounts for the lion’s share of equity gains. And just a few stocks account for the lion’s share of US gains.
The second sentence here is imprecise, as a few readers pointed out. A few stocks may be fuelling the S&P 500’s exceptional performance — our original point — but that is on the back of an already world-beating performance by large-cap US equities. One correspondent, Jordan Toplitzky of Toplitzky & Co, put it well:
The accompanying chart in your note [“A perfect ten”, above] provides a perhaps contradictory view . . . that the other 490 S&P 500 stocks managed a 20 per cent gain compared to the 40 per cent gain for the largest 10 stocks. 20 per cent isn’t too bad in my view.
Several readers also pointed us to the S&P 500 equal-weight index, or SPW. One argued that growing fears about bad market breadth don’t hold up once you look at SPW:
It occurs to me that if it is true then any index composed of equal-weighted components should show a decline in recent months. Looking at equal weighted indices for the S&P, the argument is not borne out.
And indeed, the SPW has kept up just fine with the S&P 500 over the past year:
Within the guts of SPW, though, something exceptional has happened in recent months. The index has lately been buoyed by a big run-up in energy stocks, many of which have higher weights in the SPW than in the S&P 500. For instance, Devon Energy, up 160 per cent in the past 12 months, has triple the index weight in SPW than it does in the S&P. This has made it the second-biggest contributor to SPW performance, behind electric vehicle-hype-fuelled Ford. Outsized gains in these smaller stocks are amplified by how SPW is calculated.
But over a longer time horizon, the S&P 500 beats SPW:
Over the past five years, the performance of the S&P 490 and SPW 490 (ie, excluding the biggest 10 stocks from both indices) are all but identical, suggesting that the S&P 10 makes the difference over time. Our initial conclusion that US stocks are exceptional because of the S&P 10 remains true, with the proviso that US stocks have still performed darn well without them.
What does all this tell us about market breadth? On its face, this is good news. If the S&P 10 falters, US stocks will wobble, but a healthy SPW suggests there’s other sources of strength, too.
Other measures of breadth are less optimistic. The commonly cited Bloomberg index of new 52-week highs minus lows has been bouncing around heavily negative territory for months, though it includes a much wider range of stocks than the S&P 500. This chart from Yardeni Research shows one measure of S&P 500 breadth sharply falling since early 2021:
The market is getting narrower. But remember: bad breadth is not a sure-fire harbinger of a market correction. (Ethan Wu)
One good read
The market increasingly thinks the Fed starting up quantitative tightening is just a matter of time. But how does QT work? Joseph Wang at the always-excellent Fed Guy blog has the details.