After the most dramatic pace of tightening in two generations, the US Federal Reserve may be nearing the completion of its hiking cycle. Equity market performance following the last rate hike of a cycle could have a wide range of outcomes, from a recession to a soft landing.
Our base case remains bearish, although the jury is still out.
Whatever the outcome, the 10-year US Treasury bond yield has likely reached, or is near, its peak. It has risen more than 100 basis points from the April low, with more than half of the increase occurring between mid-July and late August. 10-year yields typically peak in the five-month range four months before or four months after the peak in the fed-funds rate.
Closely tracks the 10-year Bloomberg Economic Surprise Index, which measures how often data releases beat or miss expectations. The index reached its top decile level this summer, so we would not be surprised if it tumbled, a move that would have a significant impact on equity valuations and market leadership.
For valuations, falling long-term interest rates are a good sign. Future cash flows will be discounted by smaller amounts, so the value assigned to future profits will effectively increase as the discount rate falls. This increases the theoretical value of the asset despite there being no change in the underlying cash flows.
At 18.8 times forecast next 12-month earnings, the S&P 500 cannot be called cheap. Yet with the 10-year yield above 4%, if it falls – and, by extension, discount rates also fall – market multiples will look less stretched.
Bond yields can also influence market leadership, as the recent decline in stocks shows. This summer, when the 10-year rose sharply, defensive sectors (such as utilities) and growth sectors (such as information technology) underperformed. Meanwhile, cyclicals (Energy) and value (Health Care) outperformed.
This should come as no surprise as cyclical and value stocks tend to fare better when rates rise, while equities with growth and defensive characteristics thrive more as long-term yields fall. Value stocks are priced based on cash flows for the next few years, making them less susceptible to changes in the discount rate. Growth stocks place more emphasis on future cash flows, so they may be penalized more if the discount rate increases and future cash flow values decrease.
Higher yields accompany an improving economic outlook, which typically boosts cyclical companies’ cash flows to a greater extent. When this happens, investors can often find more attractive returns in fixed income. This may further reduce the appeal of defensive measures relative to cyclicals.
Low bond yields signal a decline in US economic momentum, at a time when equity investors look for companies with more flexible income profiles and defensive-like attractive dividend yields.
In particular, the dominance of companies with growth and defensive characteristics on the S&P 500 has increased in recent years. Today, the share of the S&P 500 classified as growth, stability and defensive is more than 70%, up from 60% 10 years ago and 40% about 100 years ago.
This means the benchmark is more sensitive to changes in bond yields. If yields near or reach a peak, lower rates could help support equity valuations in a soft landing or ease the pain of a recession.
Given our expectation of a decline in rates here, we recommend leaning towards defensive and growth stocks, the sectors of the US equity market that stand to benefit the most from declines in bond yields.
Jeffrey Schultz, CFA