Rising bond yields sound like a stock-market killer. The good news for shareholders is that the market overall might be fine. The trouble lies with the FANGs and other acronym stocks that have been leading indexes higher.
Treasury yields have accelerated their climb, but it has been the wrong sort of rise: mainly due to an increase in uncertainty, rather than expectations of a stronger economy and higher interest rates. Luckily for stock investors, the trouble, largely contained to the big tech disrupters, isn’t widespread.
The rise in bond yields has been fast and painful. An investor who held benchmark 10-year Treasurys this year would have lost 5.8% by the end of last week, even after reinvesting the coupon.
Until last week this wasn’t a problem for the S&P 500 (.SPX). But the most recent bond-yield rise—the biggest in four days since the 2016 election—hurt shares because it wasn’t, contrary to what some may think, about a stronger economy and higher interest rates.
Instead, bond yields were pushed up almost entirely by a higher term premium, the extra yield offered above expected interest rates for locking up money for 10 years. (In a post-quantitative-easing quirk of the bond market, this term premium is currently negative, but less negative than it was.)
Bond investors are less sure where they stand, and so demand a higher term premium. Inflation is uncertain, with anecdotal evidence of bottlenecks and worker shortages even as hard data suggests price rises are well under control. The economic cycle is long in the tooth, with lots of debate about when the next recession will come. And Federal Reserve Chairman Jerome Powell has been emphasizing how little the central bank knows about the future.
Sure enough, shares are down a bit, and the highest-flying growth stocks are down a lot. Even Amazon.com was down almost 10% from its late-summer high to Monday’s low, while glamour stock Netflix lost even more in just four days.
There are three reasons to worry. The first is that the acronym stocks— Facebook (FB), Amazon (AMZN), Apple (AAPL), Google parent Alphabet (GOOG) (GOOGL), Netflix (NFLX), Microsoft (MSFT) and others arranged into the FANGs, FAAMGs and so on—flew too high, and will now fall hard. They were propelled higher by strong fundamentals and helped by low bond yields making profits far in the future look attractive by comparison. If rising yields have broken their upward momentum, it might turn into a downward spiral as investors try to cash in their paper profits on the acronym stocks before they vanish.
The second reason for concern is that if the term premium keeps going up, the acronym stocks should keep suffering as a result. A simple return of the term premium to where it stood three years ago, just before the Fed rate rises began, could power 10-year yields to 3.75%; a return to what used to count as normal would take it well above 4%. Discount future profits back to today at a higher interest rate and they are worth less, and that hits rapidly growing companies more than the rest of the market because more (in some cases all) of their profits are far in the future.
The third worry is that the stock market already was looking unhealthy. Since the start of September, smaller companies have been having a terrible time and bank stocks have fallen sharply. Both suggest a lack of confidence in the economic outlook. The overall market was held up by the performance of a relatively small number of large stocks in high-growth sectors, so if they stumble, the outlook is grim.
These are powerful arguments, but I am hopeful that rather than a full-blown market correction, this will be merely a rotation away from the overdone highfliers and back into some of the cheaper laggards. The gap between cheap “value” stocks and expensive growth stocks this year was huge: On MSCI’s indexes, U.S. value stocks were up just 1.6% by the end of September, while growth stocks were up 16.5%.
A shift back to value would be a welcome recognition that the future of the economy doesn’t rest with just a handful of companies. The last really big example of a rising term premium and uncertainty also worked out OK for stocks: In the 2013 taper tantrum, the term premium and yields rose further and faster than they have recently, and U.S. stocks made back their losses within a month.
There are no guarantees, and companies are both more leveraged and more highly valued than they were in 2013. But at the very least it is too early to panic about bond yields.
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