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:
“With malice toward none; with charity for all; with firmness in the right, as God gives us to see the right, let us strive on to finish the work we are in; to bind up the nation’s wounds; to care for him who shall have borne the battle, and for his widow, and his orphan—to do all which may achieve and cherish a just, and a lasting peace, among ourselves, and with all nations.” – Abraham Lincoln
Why the recent rise in rates isn’t a problem
The recent rise in global interest rates since the beginning of the year — a phenomenon most pronounced in the U.S.— has investors jittery that the equity and fixed income rallies over the past 10 months or so may soon be ending. (For bonds, an increase in yield means a decrease in price, lowering the value of existing issues. For equity investors, higher yields on “risk-free” assets such as U.S. Treasuries can make stocks relatively less attractive on a risk-return basis.)
But history tells us that all publicly traded financial assets tend to process information simultaneously. In other words, worrying that stocks may be in peril because longer-term interest rates have risen abruptly over the past two weeks ignores the fact that equity markets have been “open for business” over the same period — and thus far seem unfazed. So we’re not surprised that both the S&P 500 Index and the global MSCI All-Country World Index are up modestly thus far in 2021.3 Indeed, yields and stock prices have been positively correlated (i.e., tending to move in the same direction) on a monthly basis for nearly 20 years.4
Now, you might ask how this could possibly be true given that yields across the Treasury curve have fallen steadily since 2000, while the S&P 500 has risen, returning 7.5% per year, on average.5 It turns out that the bulk of those gains came during periods in which rates were rising or steady, while most of the losses were highly concentrated in stretches when rates were declining.
To illustrate, look no further than February-March 2020, in the early days of the coronavirus outbreak in the U.S. The 10-year Treasury yield plunged nearly 100 basis points (1%), from 1.59% on February 14 to 0.76% on March 23.6 During that same stretch, U.S. stock prices collapsed, with the S&P 500 down by 34%.7
Later on in 2020, amid signs that massive fiscal and monetary stimulus programs were fueling a strong rebound in the economy, the 10-year yield edged higher, while the S&P 500 rallied hard.
Fast forward to last week. The 10-year Treasury closed at 1.11% on January 15 — up 57 basis points from its all-time low of 0.54% on March 9, 2020.8 What’s behind this upswing? The strong possibility of a faster-growing, hotter economy ahead, with the following factors contributing:
- Georgia’s Senate runoff elections effectively flipped control of Congress to the Democrats. That should allow for the passage of a far larger stimulus package in 2021—such as the one proposed by President-elect Joe Biden—than if the Senate had remained in Republican hands. In fact, on January 6 alone, the day after Georgia voters went to the polls, the 10-year yield surged 8 basis points, its biggest one-day increase this year.9
- Personal incomes are expected to rise in the first and second quarter of the year thanks to the fiscal stimulus passed just after Christmas.
An immediate, further climb in yields would likely require some significant upside surprises in economic data, especially to core inflation, or a policy mistake by the Fed, such as a premature end to its bond-buying program or a wavering in its commitment to keep rates low. Inflation data worldwide has been running more neutral to positive lately. Investors who are more concerned than we are about a sharper, inflation-fueled jump in yields may consider TIPS (Treasury Inflation Protected Securities), gold or other real assets, which are often sought after as hedges against inflation, providing a degree of protection during periods of higher prices.
Investors expecting strong gains in global growth—which could also boost inflation — should feel confident that equity market profits in that scenario would likely exceed bond market losses. A larger allocation to cyclical (i.e., more economically sensitive) sectors of the stock market could potentially enhance returns further.
So where do we expect the 10-year Treasury yield to land by the end of 2021? Somewhere between 1.25% and 1.50%, barring a calamity that spurs a risk-off mood or severely damages the U.S. economic recovery. As for the possibility that the yield will move higher than we currently anticipate, say, above 2%, we’d need to see more than just good news on the vaccine front or the economy for that to happen.
As we see it, Treasury yields are rising for largely “good” reasons, including optimism about both vaccinations and the effectiveness of fiscal and monetary policy to help in the post-pandemic recovery. This optimism has created a benign environment for many assets other than U.S. Treasuries. Equities and credit, for example, have taken higher rates in stride and should continue to do so.
That said, while rising rates tend to be correlated with better performance from equity sectors like financials, they generally weigh on high-growth areas like technology. Beaten-down value shares, which often benefit from rising-rate environments, may also be worth considering, after lagging their growth counterparts by 6.5% annually over the past decade.10
A bit of Bitcoin? Tread carefully.
It’s not just the S&P 500 Index, Dow Jones Industrials Average and Nasdaq that have set records recently. So has Bitcoin. This cryptocurrency has soared 25% thus far in 2021, on top of its staggering 305% gain last year.11 With returns like that, is Bitcoin a worthy addition to a portfolio?
Not in our view. And here’s why:
- Bitcoin’s frequent bounces. Bitcoin is extremely volatile. Last year, it rose or fell by 5% or more in a single day 40 times.11
- Cryptic correlations. Because the correlation of returns between Bitcoin and other asset classes is highly unstable, it is virtually impossible to determine the size of a suitable allocation to it. (The same holds true for other cryptocurrencies.) For this reason, we discourage institutional investors who need to meet their annual return targets, as well as individuals seeking to achieve their personal financial goals, from investing in Bitcoin.
- Limited liquidity. Even if we concede that Bitcoin can be a viewed as a store of value comparable to other currencies, it lacks a central authority (i.e., it isn’t issued or backed by any government entity), and its supply is limited. These factors often makes Bitcoin less liquid and hard to trade.
- No income. Bitcoin generates no income and has no risk premium (i.e., it offers no expected rate of return in excess of the return of risk-free assets such as U.S. Treasuries).
None of these drawbacks means that you’re guaranteed – or even likely – to lose money buying Bitcoin. But we would view it as a speculative play rather than an investment. For investors exploring Bitcoin because of concerns about inflation, debt or the long-term viability of conventional currencies, we think better, more stable, income-producing alternatives available. These include TIPS, real estate and other real assets like farmland.