The Yields They Are A Risin’

Asset Allocation – Yields toll for thee

• Bond yields and equity markets have a rather finicky relationship. Sometimes, falling yields are good and sometimes bad. Samewith rising yields. We have opined for a few months now that the rise in bond yields, a development that started in August, is a healthy turn of events but at some point would weigh on equity markets and valuations. The markets and many asset prices have been inflated thanks to monetary policy and low bond yields. Lower bond yields are correlated with higher market valuations, so naturally rising bond yields are a headwind. But it is not that simple (it never is).

• Bond yields are rising for a very good reason: the global economic recovery continues to gain momentum on the back of vaccine rollouts putting the end of this pandemic in sight. The opening-up trade is gaining and few would argue this is a very welcome development. However, there is a pain point should yields rise too far or too fast. The equity markets experienced a taste of this in late February. The 10-year U.S. Treasury yield, which had been steadily rising, jumped over 14 basis points (bps) in one day sending equity markets into a bit of a tizzy. 

• We continue to believe that bond yields will move higher in the coming months and this will continue to weigh on equity prices, especially the more interest rate-sensitive sectors and the longer-duration growth companies (aka large-cap tech). This adjustment process to higher yields is well underway in some sectors (gold, consumer staples) and still in the early phases for many growth names. 

• This could very easily push the market into a correction (10% drop or more). The industries and companies at great risk to higher yields simply carry a heavy weight in the indices of both the U.S. and Canada, although to a lesser extent. While the companies that benefit from higher yields, like financials and cyclical yield names (Read Market Ethos on Cycle Yield HERE), have a smaller representation in the indices. 

• Looking at previous bouts of rising bond yields, it is difficult to draw hard conclusions (Chart 3). The fact is, each occurred for different reasons, in different environments and from different starting points: 1994 was over government deficits and 1999 due to an overheating economy. Perhaps the most similar to the current situation is 2009, when yields rose coming out of a recession. During the 2009 episode of rising yields, equity markets did alright, better in the early days and worse as yields got higher. We would expect a similar pattern during the current environment, if yields get too high or rise too fast, equity markets will suffer.

• Yields could keep rising for some time. This is not just because of the low starting point, but inflationary data is startingtosurface. And, any year-over-year economic data metrics released in the coming months is going to be exaggerated because the comparable from a year ago will be in the depths of the pandemic-driven shutdowns.  

• The good news is that this adjustment phase to potentially higher yields is a healthy event. It may create a correction due to valuations re-adjusting (Chart 4), which should be viewed as a buying opportunity. The fact is that the economic situation is getting better, the world is getting better and longer term this will be good for earnings and the markets. 
  

Equities – Reflation trade alive and well

• The jump in government bond yields confirms the reflationary move in the markets that we’ve been expecting. Compared to prior bond sell-offs, this period of rising bond yields has the short end of the curve locked steady while the long end has risen due to growing expectations of an economic recovery. The trend in yields has been evident since the summer, so why is the market only beginning to care now? The recent spike in the Move Index –which is a Treasury volatility measure –distinguishes the recent move compared to the far more attritional up move in bond yields last year. We should also note that it’s not just the U.S., or the Fed, or President Biden’s $1.9 billion stimulus plan; rather, it has been a global move. From Japan to Germany, yield curves have been steepening. 

• It’s not just the bond market that is demonstrating that the reflation trade is alive and well. Commodities too are screaming the same message. Oil prices have risen substantially, same with copper, lumber and food and the list goes on. Chart 5 shows the Bloomberg Commodity Index and if you just look at the past year, it would be easy to think that commodity prices have gotten a little out of control, however when you zoom out and observe longer term, commodities are barely at the foothills of what could be another super cycle. So far, the current outperformance of commodity markets is nothing like the 1970s or the early 2000s.One area of concern over the near term would be how stretched managed-money speculative positions are across the commodity space. Demand expectations are there, but so far, there has been a lot of speculative money driving prices higher. 

• While a lot of attention has been paid to the likes of GameStop and other isolated asset mispricings, the reflationary trade has been driving a growing sector disparity in equity markets. The clear winners are Energy, Materials, and Financials as Chart 6 clearly illustrates in both Canada and the U.S. It’s also the reason why Canada has been outperforming U.S. markets year to date as the TSX’s combined weight of these sectors is ~55.3% versus ~16.7% for the S&P 500. Interest-rate sensitive sectors have had a tough time, with Utilities and Telecom names struggling. 

• Markets do trend –momentum investors have built careers off this –but they also reverse, and when momentum reverses it can happen quickly. Tech tried its best to reverse course and play catch up but is having a difficult time coping with higher bond yields. As we noted in a recent Market Ethos, many of the cheaper value areas are inflecting materially higher and we expect to see a pull back in expensive growth areas. The reflation trade means that big tech and recent MOMO (or momentum) winners have lost their MOJO. The value versus growth rotation still has room to run. 

• Markets are doing what they are supposed to do: discount events before they happen. With bankers eager to provoke inflation, and “go big” the common mantra for fiscal spending plans, we believe that the reflationary trade –while potentially overheated in the near-term –has staying power. Inflation has yet to rear its ugly head in the data, but the fear of inflation is what moves markets, not just a monthly data release. 
  

Equities – Emerging Markets

• In September 2020, we added exposure to Emerging Markets (EM), then added again at the start of this year. We were expecting to see a rotation out of U.S. stocks into non-U.S. names while also under the notion that EM tends to outperform at the start of an expansion and reflationary environment. 

• The trend started in the summer and has continued as economies around the world slowly recover from the pandemic. Semiconductor and commodity prices have also added to the outperformance. 

• A restocking of semiconductor inventory has aided EM, in particular South Korea and Taiwan, but much of these growth expectations are likely already priced in. There is still a shortage, but it is waning. 

• The Materials sector, on the back of stronger commodity prices, is the other area of optimism for EM because of the strong correlation between the two. Absolute forward earnings growth is expected to be in the mid ~20% range over the next 12 months. Industrial metal prices have also been on a tear, but historically are quite volatile and tend to be mean reverting. 

• Much of the gain in industrial metal prices comes off the back of the early recovery in China’s economy. Demand for base metals could be sustained as the rest of the world continues to recover.

• China dominates the EM index, accounting for 38%. Chinese returns tend to do well when house-price increases are muted and access to leverage is readily available, as is the case now. 

• With China, Korea and Taiwan accounting for almost two thirds of the EM index, they have driven index returns as of late. The Asian market outperformance is likely going to need to continue for the trade to keep working. 

• Like the mega-cap concentration in the S&P 500, 22% of the EM benchmark is made up of just four technology stocks. 

• When we look at EM, we look at EM ex-China as well. Ex-China EM offers a more clinically oriented global exposure versus a domestic Chinese earnings exposure trade. Ex-China EM accounts for one-fifth of the world’s energy and resource stocks. 

• As a result of our analysis and based on the confluence of reasons above, we are sanguine about EM and remain slightly overweight. We are not adding at this point because the easy money appears to be baked into prices. However, the space should benefit from the reflation trade and should fare better than other regions in a rising rate environment. 

Charts are sourced to Bloomberg L.P. unless otherwise noted.

The contents of this publication were researched, written and produced by Richardson Wealth Limited and are used herein under a non-exclusive license by Echelon Wealth Partners Inc. (“Echelon”) for information purposes only. The statements and statistics contained herein are based on material believed to be reliable but there is no guarantee they are accurate or complete. Particular investments or trading strategies should be evaluated relative to each individual's objectives in consultation with their Echelon representative. 

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The opinions expressed in this report are the opinions of its author, Richardson Wealth Limited (“Richardson”), used under a non-exclusive license and readers should not assume they reflect the opinions or recommendations of Echelon Wealth Partners Inc. (“Echelon”) or its affiliates.

This is not an official publication or research report of Echelon, the author is not an Echelon research analyst and this is not to be used as a solicitation in a jurisdiction where this Echelon representative is not registered. The information contained has not been approved by and are not those of Echelon, its subsidiaries, affiliates, or divisions including but not limited to Chevron Wealth Preservation Inc. The particulars contained herein were obtained from sources which we believe are reliable, but are not guaranteed by us and may be incomplete.

Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. Echelon and Richardson do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. These estimates and expectations involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.

Forward-looking statements are based on current expectations, estimates, forecasts and projections based on beliefs and assumptions made by author. These statements involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.