The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2021 Outlook:
- U.S. economy: Getting worse before it improves.
- Global economy: Ready to get back to normal—with the help of vaccines.
- Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
- Fixed income: A modest-risk overweight with a focus on credit sectors.
- Equities: Lean toward small caps, emerging market shares and dividend payers.
- Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
Quote of the week:
"In the depths of winter, I finally learned that within me lay an invincible summer.” – Albert Camus
Why rising bond yields aren’t likely to derail the economy or markets
Two months into 2021, the global economy is in far better shape than we or most other observers expected just a few months ago. With some exceptions (most notably, the eurozone), vaccinations are proceeding at an impressive pace and are already showing signs of efficacy. U.S. economic data is once again exceeding expectations, thanks in no small part to the December stimulus package. Lastly, central banks around the world are maintaining easy monetary policy despite aggressive upgrades to 2021 economic forecasts in their respective countries, and more fiscal stimulus globally is set to arrive imminently.
So, what’s the problem? Well, part of the potential upside scenario that we identified heading into this year was a sharper rise in interest rates — a challenge for a Federal Reserve looking to stay exceptionally dovish for longer than it did in the aftermath of the global financial crisis.
Last week’s jump in long-term rates, which saw the 10-year U.S. Treasury yield surge 16 basis points (bps) on Thursday alone and 10 bps for the full week to close at 1.44%, reflects U.S. economic growing pains.4 These sudden lurches higher can be jarring for investors, but they don’t represent a threat to the recovery in equity markets or the broader economy. In fact, the recent rise in rates reflects the Treasury market’s view that the outlook has grown stronger. This perceived strength is also evident in commodity markets, where oil and copper prices have been climbing. Credit markets seem unperturbed by the jump in rates, as well; spreads on high yield corporate bonds are only a touch higher than their lows for the year.
Here’s what’s important to keep in mind: despite their rapid increase, rates remain very low by historical standards. For example, the average 10-year U.S. Treasury yield over the past decade was 2.13%. Over the past 20 years, it was 3.13%.5
Some of the recent rise in interest rates has come as inflation expectations have moved higher, but the increase isn’t a cause for alarm. While core PCE inflation — the Fed’s preferred inflation barometer — surprised on the upside in January, a true breakout remains unlikely in the months ahead. Two factors help explain why inflation expectations and real interest rates (the nominal rate minus inflation) are still low even in the face of unprecedented fiscal stimulus and a once-in-a-lifetime economic reopening:
- First, the Fed is holding the line on its target federal funds rate (currently in a range of 0% to 0.25%) and monthly quantitative easing asset purchases ($120 billion per month). Fed Chair Jerome Powell gave no indication during his semiannual Congressional testimony last week that any changes to these dovish policies were being considered.
- Second, the consensus on structural inflation risks has shifted dramatically in the last ten years or so. In 2011, responding to the question, “What will it take to produce high inflation?,” a typical economist might have suggested the U.S. economy would begin to overheat once unemployment fell below 6.5%. Yet the unemployment rate stayed lower than 6% from September 2014 through March 2020 — a period lasting 67 months, or more than 5½ years — and inflation exceeded the Fed’s 2% target in just nine of those months.6
Will the Fed’s recently adopted tolerance for the economy to run hotter to compensate for periods of low inflation (such as that seen during the pandemic) herald a return of inflation risk to investor psychology? It’s possible. But February’s bond market selloff failed to produce a significant pullback in broad equity indexes. (On the contrary, the S&P 500 rose about 2.7% last month, despite a weak finish.7) Bottom line: Investors expect inflation to increase this year, but not by enough to knock the Fed off its dovish course. We agree.
What’s up (and down) in financial markets this year — and why
How are asset classes performing in 2021 thus far? There’s a wide performance gap between the winners and losers, especially after just two months. Year to date through February 26, the small cap Russell 2000 (+11.6% total return), mid cap stocks (+5.3%) and emerging market equities (+3.9% in dollar terms) are leading the pack. In contrast, 30-year U.S. Treasuries (-10.3%), investment-grade corporate bonds (-3%) and U.S. dollar-denominated emerging market (EM) debt (-2.3%) have lagged.7
The primary driver of this disparity of returns: interest rates. In rising rate environments like the one markets are experiencing now, some assets benefit while others suffer. Starting from the bottom, 30-year Treasury bonds and other longer-duration assets like U.S. investment grade corporate bonds always struggle when interest rates rise briskly. (Duration measures a bond’s sensitivity to changes in rates. The longer a bond’s maturity, the higher its duration, and the more its price will fall as rates rise.) Meanwhile, dollar-denominated EM bonds have struggled as their yields have followed those of U.S. Treasuries.
In contrast to fixed income, stocks have rallied this year. This isn’t surprising, as equities generally outperform bonds in periods of rising rates. Since 2014, the correlation between weekly changes in the 10-year U.S. Treasury yield and the S&P 500 Index has almost always been positive, meaning rates and stock prices tend to move in the same direction.8
U.S. small-cap stocks often perform particularly well in rising rate environments, which tend to occur in earlier parts of the business cycle, as the economy emerges from recession or periods of slow growth. But their outperformance is also due to their sector composition. Compared to large and mid caps, the Russell 2000 Index, a widely used small cap benchmark, has a larger weight in financials, which are aided by an upswing in rates and a steeper yield curve.9 That’s because banks, a substantial component of the financials sector, benefit from the wider spread between short-term rates (which determine the interest they pay on deposits) and long-term rates (on which they base how much interest they charge on loans).
Additionally, the small cap index holds a lower concentration in technology stocks.10 Tech stocks were last year’s market leaders due to their potential for delivering growth when many companies were struggling to stay afloat, but they have lagged in 2021. They’re sometimes likened to long-duration bonds in that their “yield” is their expected delivery of high earnings growth. As rates climb, the present value of those anticipated earnings fall.
Lastly, because small caps were especially hard hit by the pandemic, they’ve had much more room for gains in recent months, playing catch-up as the economy reopens.
Sector breakdowns have also helped EM equities, particularly their weightings in financials and energy, which has surged on rising oil prices.11 And they’ve benefited from a weaker U.S. dollar, which amplifies returns for dollar-based investors. Surging inflows into the asset class have acted as a tailwind as well. Emerging markets tend to attract capital when the global economy seems primed to accelerate in synchronous fashion — even if the economy that picks up the most steam (likely the U.S.) isn’t itself an emerging market.
Also noteworthy in 2021: value stocks (+5.7%) have handily outpaced growth (-0.2%), a rarity over the past decade or so.12 Part of value’s stronger showing relative to growth reflects its lower weighting in technology and higher weighting in financials. But this year’s outperformance has barely made a dent in growth’s dominance over value during 2020.
Can this overall performance hierarchy continue in 2021? Maybe. Both value and small cap stocks tend to be more cyclical (i.e., economically sensitive) than their growth and large cap counterparts, and that could augur well for them if the recent string of positive economic news persists. We think it can.