Is it Taper Tantrum déjà vu? Sure feels that way!
The sudden return of stock market volatility in recent weeks seems like a repeat of the May 2013 Taper Tantrum, when the U.S. Federal Reserve (the Fed) signaled its intention to “taper” its asset purchases. Stocks went down, bond yields rose sharply, and credit spreads widened. It was a trifecta of unwanted correlations among the major asset classes.
It was an important lesson for the markets at the time, and especially for the Fed, as the financial system was not able to withstand the end of monetary policy accommodation (conventional or otherwise). Fortunately, the Fed “got it” and the whole thing was over in a few weeks. But the scars are still with us, and we see them every time that real interest rates (rates adjusted for inflation) start to rise in the absence of economic growth.
This time around credit spreads have been well behaved, but the dynamic we saw in 2013—when stocks corrected while bond yields rose—is happening again. The S&P 500® Index has declined 3.5% from its August 23 high of 2,194, while the 10-year Treasury yield has risen 43 basis points (bps). Normally, equity market corrections occur as a result of a deflation scare, which tends to bring bond yields down instead of up. But both this correction and the 2013 Taper Tantrum produced the opposite result. Why? It’s the byproduct of a Fed that very much wants to tighten policy and a market that very much wants the Fed to stand pat. When the Fed gets more hawkish in its guidance than the market is comfortable with, the market has a “tantrum.”
The result in 2013 was that the Fed had to back off from reducing its asset purchases. This time around, with the Fed declining to raise rates at its September meeting, that dynamic is still in play. The central bank’s official dual mandate is to achieve full employment while maintaining price stability. These days, however, with the global economy in secular stagnation mode, it seems the Fed wants to zig while other major central banks—such as the European Central Bank (ECB) and Bank of Japan (BoJ)—are zagging. It’s as if the Fed has an unspoken third mandate in the form of not upsetting global financial conditions (i.e., to “do no harm”).
The linkage is actually pretty straightforward. When the Fed gets too aggressive for the market’s liking while the rest of the world is in easing mode, the dollar strengthens. When the dollar gets bid up, financial conditions tighten. And when financial conditions tighten, stock market volatility increases. It’s really that simple.
Why do interest rates matter so much?
In my opinion, the market’s heightened sensitivity to changes in interest rates is a function of the secular stagnation regime in which we currently live. Changes in yields have an outsized impact on the market when there is insufficient earnings growth to support stocks.
A rise in real (and nominal) yields in the absence of economic growth is one of the things that investors fear most, especially these days with interest rates as low as they are. And we just got a taste of that again. When yields rise amid an acceleration of growth, then it’s all good. But when economic growth isn’t there, it’s a problem.
Think of it in terms of a discounted earnings model. If earnings are growing at robust clip, the impact of higher interest rates (against which this earnings stream is discounted) is not nearly as meaningful as when earnings are not growing. As of this writing, the year-over-year percent change in earnings per share (EPS) is –1.4%, and the growth rate has been falling for almost two years. Meanwhile, the 10-year Treasury yield has climbed to 1.6%. That’s a meaningful uptick from the low of 1.3% in late June immediately after Brexit, when the market mistakenly believed the Fed was as likely to ease rates as it was to tighten them.
Still, one wouldn’t think that a move from 1.3% to 1.6% was such a big deal. After all, even 1.6% is lower than most people could ever imagine just a few years ago. But in the absence of earnings growth it makes a large difference to the fair value of the stock market (see chart). As the chart shows, if the 10-year Treasury yield rose 100 bps in the absence of any earnings growth, that would leave the S&P 500 overvalued by about 20% (assuming no changes in the equity risk premium,1 which is the second component of the discount rate against which the earnings stream is discounted). If the Treasury yield were to fall 100 bps, that would leave the market 20% undervalued. Such is the power of interest rates when there is no earnings growth.
Now, if the aforementioned scenario were to happen when earnings were growing at their historical trend of 6% per year, it’s a whole different story. At 6% EPS growth and current interest rates, my model suggests the S&P 500 belongs at 2,779 instead of its current level of 2,148 (as of Sep. 26). If the 10-year Treasury rose 100 bps against that backdrop, the S&P’s fair value would be 2,249, which is still higher than where it is now. And if the 10-year yield fell 100 bps against this 6% earnings growth backdrop, the S&P 500 would be worth 3,627!
Thinking of this another way, if the 10-year Treasury yield was not at 1.6% but more in line with the long-term trend in nominal GDP (which is around 3%), then at zero earnings growth the market would be 31% overvalued. However, that same interest-rate scenario at 6% earnings growth would leave the market only 7% overvalued. Such is the power of low interest rates when growth is slow. This is why we get taper tantrums when rates rise in the absence of earnings growth.
An opportunity to rebalance
Here are two key questions from my perspective: Is this shift toward higher yields, lower valuations and tighter financial conditions the start of a major trend? Or will it be like every other episode of the past few years—a temporary mean reversion against the prevailing trend toward lower yields and ongoing stock market support?
I think it’s the latter, simply because without a sustainable increase in growth every uptick in yields should be inherently mean-reverting, at least as long as central banks keep listening to the markets. With both the Fed’s and the Bank of Japan’s September policy meetings concluded, there is no question in my mind that global central banks remain in “do no harm” mode, meaning that they will either keep easing (in the case of the ECB and BoJ) or refrain from tightening (in the case of the Fed) if the markets aren’t completely on board with a regime shift toward higher real rates.
With debt levels high and demographics and productivity growth where they are, I don’t think a regime-shift toward higher yields is in the cards. Not yet, at least. In my view, the Fed has learned its lesson with regard to the risks of imposing a policy error on the markets.
Therefore, the recent episode of jawboning by the Fed should, in my opinion, be seen by investors as an opportunity to rebalance their portfolios. For example, if an investor doesn’t have enough bond duration, then the recent backup in yields could be seen as an opportunity to add some, given the mean-reverting dynamic described.
Technically, the recent low point for the S&P 500 was 2,117 (Sept. 12), right at that former breakout point from which the market jumped to new highs over the summer (2,100 to 2,130). Markets that break out of large trading ranges (as the S&P 500 recently did) often return to the scene of the crime and test what has now become support.
So whether or not the market can climb higher from here will be an important test. Within that context, keep in mind that September historically has been the weakest month of the year for stocks. From 1927 to 2015, the U.S. stock market has declined by an average of 1.1%, according to Bloomberg Finance L.P.
So, we have a market that has corrected lower based on an assumption that the Fed might raise rates when it shouldn’t, and the market is retesting its previous breakout point at the time of year when corrections typically happen. If the market survives these tests as October progresses, it could bode well for stocks for the remainder of 2016. And that means that now may be an ideal time to find potentially attractive growth opportunities at discounted prices.
Food for thought.
Investing involves risk, including risk of loss.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
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