For the week ending November 8, 2019
This publication is provided by Bryn Mawr Trust Wealth Management.
Rates are Rising and The Yield Curve “Un-Inverts”… What’s the Message? Higher rates have been grabbing market headlines of late. Since the beginning of November, the 10-year U.S. Treasury yield has risen from 1.69% to 1.93%. On a percentage change basis, this is a 15% move in a week — not insignificant. Should equity investors be concerned? We all remember what happened in 2018 when the 10-year Treasury yield climbed to more than 3.0% — global markets seemed to have a problem digesting higher rates. In our view, the present situation reflects some important differences.
- For one, the Federal Reserve (Fed) and other global central banks are no longer hiking interest rates. As a result, we do not believe equity markets will extrapolate a rapid move higher in rates, even if yields continue to drift higher from current levels.
- The interest rates experienced over the summer (whether the 10-year U.S. Treasury yield at 1.50% or the 10-year German Bund at -0.70%) were reflective of an overly pessimistic view of the economy. We believe the economy is actually improving versus getting worse.
- Higher rates (within reason) are likely a welcome sign for investors, as it provides evidence that the bond market is not predicting a significant issue with the economy.
- Along with the move higher in rates, we have seen a steepening of the yield curve. This represents a reversal of a market condition that often occurs prior to recession, and that most market-bears were quick to highlight.
We analyzed the daily performance of the S&P 500 relative to daily moves in interest rates so far in 2019 to understand how interest rates have been impacting stocks. Contrary to popular belief, stocks have accrued almost all of their gains this year on days when interest rates increased. This is actually the typical pattern investors would expect to see, as stock and bond prices often move in different directions – when people feel good, they sell bonds (pushing rates higher) and buy stocks (pushing stock prices higher). However, the past 10 years have conditioned us to believe we need low rates for stocks to rise. Certainly not the case this year.
- On days when interest rates fell, stocks have returned a combined -24.84% this year
- On days when interest rates rose, stocks have returned a combined +40.11% this year
- On days when interest rates were more or less flat, stocks returned a combined +6.24%
Source: FactSet, Inc.
The Beginning of a Cyclical Rotation. One way to gauge market sentiment is to examine the performance of more cyclical, or economically sensitive, sectors such as Energy, Financials, Industrials, and Materials relative to defensive sectors like Health Care, Utilities, and Consumer Staples. This past week, investor willingness to take more risk was encapsulated by the favorable performance of cyclical sectors and value stocks, more broadly.
There has been considerable media attention about the long-awaited rotation into cyclical stocks as global trade tensions have eased, manufacturing activity appears to have stabilized, and interest rates have started to move higher. We have seen short periods of outperformance from value and cyclical sectors several times throughout this market cycle. The question now is whether this latest rotation will last. We believe a more durable rotation is likely, but not until sometime in the first quarter of 2020.
There have been multiple occasions this cycle when long-term interest rates rose, and then reversed back to lower levels. Such an environment occurred early in September of this year. The table below shows the performance of S&P 500 sectors since the beginning of September of this year. For the first two weeks in September, interest rates (10-year Treasury yields) rose more than 40 basis points. The market, as measured by the S&P 500 Index, over this time period rose more than 3.5%, with cyclicals leading the way. Interest rates fell over the following six weeks and cyclical stocks lagged.
S&P 500 Returns
|S&P 500 Sec/Cons Disc TR USD||3.54||-1.90||0.43|
|S&P 500 Sec/Cons Staples TR USD||-0.01||1.04||-0.52|
|S&P 500 Sec/Energy TR USD||6.80||-4.61||4.97|
|S&P 500 Sec/Financials TR USD||7.14||1.15||4.04|
|S&P 500 Sec/Health Care TR USD||1.60||3.93||0.48|
|S&P 500 Sec/Industrials TR USD||6.27||-0.61||4.17|
|S&P 500 Sec/Information Technology TRUSD||3.35||3.34||3.00|
|S&P 500 Sec/Materials TR USD||5.25||-1.13||3.50|
|S&P 500 Sec/Commun Services TR USD||4.52||0.00||2.01|
|S&P 500 TR USD||3.58||1.17||1.91|
Source: Morningstar, Inc.
Before making any pronounced tactical recommendations related to cyclical sectors, we would prefer to see more evidence of stabilization in leading economic indicators, such as global manufacturing data. Our analysis forecasts an upturn in data like the Manufacturing Purchasing Manager Index in the first quarter of 2020.
Sentiment Less of a Tailwind, but Backdrop still Favorable into Year-End
As so aptly stated by famous investor John Templeton, “Bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria”. For the past number of weeks, we discussed the idea that the sentiment backdrop was supportive of the market. In other words, investors have not been optimistic, and that lack of optimism created both potential upside and a limit to the downside. As markets have notched new highs, the sentiment backdrop is starting to become more optimistic. We would certainly not call the shift euphoric, but negative sentiment is slowly unwinding, therefore becoming less of an asset for the market in the near-term. As optimism increases, the market becomes more vulnerable to deeper corrections as investors start to price-in more good news. None of the data below is cause for major concern or would forecast a high likelihood of a deep market pullback, but it is worth noting the recent shift. Perhaps a pause, or minor pullback, before a resumption higher is the most likely path for stocks at this stage.
American Association of Individual Investors: Bulls minus Bears Survey
Negative readings mean Bears are outnumbering Bulls (a reflection of skepticism). At +16%, although not at all extreme, we are slightly above the long-term average now with 16% more Bullish respondents than Bearish respondents. We have not seen Bulls outnumber Bears to this degree since May of this year.
AAII Sentiment Survey
Source: Bryn Mawr Trust; FactSet, Inc.
The Options Market
When put-option buying outpaces call-option buying it is a sign that investors are more concerned about protecting the downside than they are about capturing a move higher. Extreme put/call readings can give us a good indication of near-term market expectations, and readings in the 95th percentile are often followed by better than average returns over the next 3 and 6 months. In early October, we saw very high put/call ratios (pessimism). Although not yet extreme, this has also reversed in recent weeks.
Ratio of Put Options to Call Options
Source: Strategas Research Partners