The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Midyear Outlook :
- U.S. economy: The growth rate has peaked but will remain high throughout 2021.
- Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
- Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
- Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
- Equities: The best opportunities may now lie outside the U.S.
- Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.
Quote of the week:
“The most dangerous person is the one who listens, thinks and observes.” – Bruce Lee
What’s up with the 10-year U.S. Treasury yield?
Few securities get as much attention as the 10-year U.S. Treasury note, and for good reason. It’s a key barometer for financial markets, influencing borrowing costs for individuals and corporations. And it serves as a gauge for long-term U.S. growth and inflation expectations.
Last week, the 10-year yield garnered plenty of headlines. It spiked to a three-month high of 1.55% on September 29, up 27 basis points (bps) since mid-September, before closing the week at 1.48%.4 What’s been behind this dramatic move? A number of factors appear to be at work, including:
- Taper time. Yields typically rise when markets perceive the Federal Reserve’s mood as hawkish. And at its September 22 meeting, the Fed all but confirmed it will announce a tapering plan in November. Additionally, the Fed’s outlook for growth, inflation and policy rates for 2022 all rose compared to its June forecast.
- Dandy data. Better economic news tends to push up yields. U.S. data releases published in September — including August retail sales, housing starts and durable goods — all topped forecasts, contrary to what might have been expected given weakening sentiment as measured by from Purchasing Managers’ Indexes (PMIs) and consumer confidence surveys. (Both of these metrics have become increasingly subject to the whims of COVID-19 fears.)
- Decreasing Delta. Cases of the variant in the U.S. and around the world are falling. Prior periods of decline have been associated with rising interest rates, as markets expect economic activity to pick up.
- Capitol conflict. The odds of a large tax increase for U.S. individuals and businesses in 2022 appear to be falling as dual spending bills (on infrastructure and social policy) teeter on the edge of failure or significant shrinkage. In addition, political brinksmanship on the debt ceiling could be prompting investors to demand higher yields on U.S. Treasuries.
Here’s yet another possibility: The jump in the 10-year yield could simply be a reversal of July’s 26 bp drop, from 1.45% at the beginning of the month to 1.19% less than three weeks later.5 That sharp decline was fueled by fears of decelerating growth, exacerbated by perceptions that the Fed would begin to withdraw its ultra-easy monetary policy prematurely, potentially derailing the U.S. economic recovery.
In our view, higher rates are not the start of a new phase of the reflation trade, which found favor in early 2021. Back then, economically sensitive value stocks (such as those in the financials and energy sectors) and commodities all rallied as yields rose in anticipation of a durable acceleration in U.S. GDP.
So what’s the big picture? The U.S. is in the early-to-mid stages of the economic cycle, evidenced by falling unemployment rates, the restocking of depleted inventories, elevated savings rates and yields rising from low levels. GDP growth is past its peak from the first quarter (+6.3% annualized) and second (+6.7%), and should continue to slow in 2022.6 After all, the post-COVID economic reopening boom will happen only once. Moreover, consumer demand is bound to soften without a boost from fresh stimulus such as checks from the government, which are not forthcoming.
Looking ahead, we believe the 10-year yield has a bit further to climb this year before hitting 2% in 2022. Meanwhile, the Fed will likely remain more patient than the market expects. Thanks to its willingness to tolerate hotter inflation before tightening policy, we don’t expect “rate liftoff” to begin until 2023, even as the core PCE index — the Fed’s preferred inflation barometer — ticks above its 2% target.
U.S. stocks and bonds basically tread water in the third quarter
“It’s not where you start,” athletes often say, “but where you finish that counts.” As far as investors are concerned, the S&P 500 Index, the bellwether 10-year U.S. Treasury yield and many fixed income asset classes started and finished the quarter at about the same spot.
The S&P 500 posted positive returns in July (+2.4%) and August (+3.0%), extending its monthly winning streak to seven consecutive months.7 Driving the summer rally were surging corporate earnings, which handily topped forecasts despite rising employment costs and producer prices, which would normally crimp profit margins. A challenging September (-4.7%) nearly erased the previous two months’ gains amid concerns about global growth, perceptions of a more hawkish Fed, U.S. fiscal policy uncertainty, increased inflation expectations and the failing financial health of Evergrande, one of China’s largest real estate developers.8
For the quarter as a whole, the mostly large-cap S&P 500 returned 0.6%, incrementally lifting its year-to-date advance to 16%.9 Its valuation (measured by its price/earnings ratio) fell from 21.4 as of the end of the second quarter to just under 20 on September 30, reflecting small price gains for its constituent stocks overall combined with stellar earnings.10 Meanwhile, the more economically sensitive small-cap Russell 2000 Index lost ground (-4.4%).11
There was little dispersion among sector returns for the quarter, although cyclical areas such as energy and materials lagged as the pace of U.S. GDP growth slowed from 6%+ in the first and second quarters to a more measured pace, with the positive impact of fiscal and monetary policy fading.
International equities posted mixed results. Based on MSCI indexes in local currency terms, developed markets (+1.3%) substantially outpaced their emerging-market (EM) counterparts (-6.7%). Because non-U.S. currencies weakened against the U.S. dollar, these returns were lowered to -0.5% and -8.1%, respectively, for dollar-based investors.12 EM stocks fell victim to a slowdown in China’s economy.
In fixed-income markets, the yield on the 10-year Treasury rose just 7 bps, from 1.45% to 1.52%, amid the choppy moves described in the prior section.13 In terms of individual asset classes, Treasury Inflation-Protected Securities, or TIPS (+1.8%), led the way, fueled by multi-year highs in Consumer Price Index (CPI) inflation for July and August.14 Senior loans (+1.1%) and high yield corporates (+0.9%) delivered modest gains against a fundamentally sound economic backdrop.15 Investment-grade bonds (+0.1%) were essentially flat, as measured by the broad Bloomberg U.S. Aggregate Bond Index.16 EM debt (-0.5% in dollar terms) underperformed.17