- Is the current bout of inflation truly transitory?
- Where might interest rates go from here?
- Is there an alternative to value stocks?
- How to stay invested in technology and growth stocks.
Vaccines, pent-up demand, and expansionary fiscal and monetary policy have driven an impressive economic recovery and strong equity market performance. But the trends that seemed undeniable earlier in the year—rising inflation, rising interest rates, and the value stock rotation—have come into question at the halfway mark. In our 2021 Mid-Year Outlook we’ll address key questions on investors' minds, including:
Inflation has certainly made headlines of late with Core CPI and the PCE deflator spiking to levels not seen in over 30 years. Calming words came straight from the Fed insisting that the spike was transitory and related to temporary supply chain disruptions and other similar issues. Here’s a key data point supporting the transitory assertion: capacity utilization. Yes, it’s an old school–or perhaps old economy–measure of manufacturing, mining, and utilities. However, if inflation is temporarily spiking from more or less physical mismatches of things, a low reading from capacity utilization would be a nice confirming indicator that it’s transitory.
Capacity utilization tracks the extent to which the installed productive capacity of a country is being used in the production of goods and services. For some countries this concept is reported as the percent of capacity being used for production (as opposed to being idle). For other countries, this concept is measured through business surveys (tracking business leaders’ opinions of their use of productive capacity).
PCE deflators (or personal consumption expenditure deflators) track overall price changes for goods and services purchased by consumers. Deflators are calculated by dividing the appropriate nominal series by the corresponding real series and multiplying by 100.
The old rule of thumb is that sustained inflationary pressures only happen when capacity utilization rises above 80, as we experienced in the 1970s and 1980s. It’s noteworthy that it has remained below 80 for nearly this entire century. Perhaps that’s part of the “new normal” story.
Not so fast. The observed yield on a U.S. Treasury—often called the nominal yield—can be split into two parts: an inflation component and a “real yield” over and above inflation. With the yield on the 10-Year U.S. Treasury standing at around 1.5%, it’s readily apparent that even if the latest inflation readings of well over 3% are transitory, the real yield is negative even if inflation retreats to the Fed’s long-term target of 2%.
The long-term average 10-Year U.S. Treasury Yield is over 4%—roughly 2% inflation, and a 2% real yield. There’s no mystery as to why yields are so low. It’s quantitative easing. Bond investors are right to look for signs of any initial discussions around tapering to assess the level of risk that these yields could rise to more normal levels. But here are a couple of things to think about.
First, we are likely at peak quantitative easing, so the risk is likely asymmetric, and rates can go significantly higher but not much lower. For example, the Bloomberg Barclays Long US Treasury Index lost nearly 19% from the lows of interest rates last summer and their recent peak, earning back just over 6% in the recent retreat of rates. The 2022 Bloomberg consensus for the U.S. 10-Year Treasury Yield is 2.2%—enough to do some damage to bond prices.
Second, beware of conflating inflation risk with interest rate risk. We’ve made the case that interest rates may rise with or without inflation rising. Many investors look to TIPS (Treasury Inflation Protected Securities) to protect from rising interest rates. But TIPS only offer protection from rising inflation (technically inflation expectations)—not overall rising interest rates. Year-to-date, the Barclays US Treasury Inflation Protected Notes Index is up less than 2% as the rise in inflation (expectations) was offset by the rise in the U.S. 10-Year Treasury Yield itself. And that’s only courtesy of that recent pullback in 10-year yield. In early 2021 the index had lost as much as 2.5% as treasury yields rose without inflation expectations rising. And that’s the point. For investors concerned about rising interest rates, TIPS offer only partial protection, and if those interest rates rise without inflation expectations rising—as may very well be the case—TIPS could find themselves on the losing side of that trade. See our fixed income section for more on this.
Bonds are defenseless against rising interest rates. Their coupons are fixed, so if yields go up, price goes down. On the other hand, stocks grow—they can grow their earnings, cash flows, and dividends. The relationship of stocks to rising interest rates is therefore a complicated one. Low interest rates have historically supported higher valuations, but rising interest rates have not necessarily driven down stocks. If those earnings, cash flows, and dividends are growing sufficiently to offset those rising interest rates, stocks can do just fine—as they are right now.
Still, there are clearly some stocks that are more expensive than others. Sure, but if the answer was simply to buy cheap stocks, value stocks wouldn’t have underperformed for the last two decades. And even cheap isn’t that easy to define. This first chart shows the relative price-to-book of growth stocks over value stocks. It’s now at roughly its pre-tech bubble peak. Time to run? Not so fast.
Source: Bloomberg. The price-to-book ratio compares a firm’s market-to-book value by dividing price per share by book value per share.
Here’s a picture of that same relative value approach, but this time we use price-to-EBITDA (earnings before interest, taxes, depreciation, and amortization). Now we are nowhere near that pre-bubble peak. Tech and other growth stocks are a lot more profitable today than they were 20 years ago.
But what about rising interest rates? Those growth stocks have more of their earnings, cash flow, and dividends further out into the future. This longer “duration” must make them more sensitive to rising interest rates. Theoretically perhaps, but practically, go ahead and put together the most sophisticated discounted cash flow model for your favorite growth stock and play around with changing your discount rate by 25 basis points (bps), or 50 bps, or even 100 bps, and compare that to the impact of changing any of your other assumptions, and it will become clear rising interest rates are far from a clear sell signal for growth stocks.
In our equity section, we’ll discuss how a dividend growth approach can identify both “cheap” and “expensive” stocks that may have better odds of meeting and exceeding investor expectations, while also navigating economic impacts such as rising interest rates. And consider this: the bottom 90 stocks in the NASDAQ-100 have an average index weight of one half of one percent: An off-the-shelf market-cap weighted index approach may be missing many of those opportunities.
The month of June saw U.S. Large Cap Growth performance return to the top of the charts. Still, the story of the first half is that everything went up except bonds, with inflation-driven commodities taking the lead.
Here’s a list of upcoming key economic releases, which can serve as a guide to potential market indicators.
Major domestic equity benchmarks kept marching higher in the first half of 2021, with the S&P 500 closing out June at another record high. The economic recovery continued to gain steam and the Fed remains accommodative. Good news indeed, but there seemingly is always that wall of worry to climb. These days, valuation is front-and-center on that proverbial wall. Traditional valuation metrics, even after adjusting for today’s low interest rates, still appear at least mildly elevated relative to historical norms. Precisely what will drive future returns as we look to the remainder of the year?
The good news is that the first half market gains were not driven by valuations moving still higher from the elevated levels at the end of 2020. In fact, price-to-earnings (P/E) valuations for the S&P 500 have stabilized at approximately 30 times (on a trailing 12-month earnings basis). If the price has been moving higher while the P/E ratio is not, it must be that the “E” has also been rising. And indeed, earnings growth from corporate America has been robust since the depths of the pandemic. Q1 2021 year-on-year earnings growth was 53%. The even better news is that analyst estimates for future earnings growth from here keep moving even higher. Companies aren’t just meeting estimates with robust growth rates, they are smashing through them and raising future guidance.
Just three short months ago, analysts were expecting just over a 52% improvement in corporate earnings for Q2 2021 over Q2 2020 COVID-impacted levels. Fast-forward to the end of June, those expectations are now materially higher at just under 63% year-over-year growth. For the full year, earnings are now expected to grow just over 35%. The market’s fundamental earnings picture keeps getting better. What does all this potentially mean for markets for the remainder of the year? If recent trends continue, better-than-expected earnings may just be the fuel needed to propel the markets higher, while also bringing valuations back to more reasonable levels.
Price-to-earnings (P/E) is the ratio of the price of a stock (or index) to the earnings per share.
Source: FactSet as of 6/25/2021
None of this is to suggest equity markets are in the clear and that it will be smooth sailing as summer heats up. Market returns aren’t typically linear, despite the current string of five consecutive quarters of gains for the S&P 500. Plenty of risks remain that will influence stock prices, including the direction of rates and the staying power of the continued economic recovery. At some point, today’s lofty earnings growth numbers will moderate. Some companies—perhaps even some of the largest market cap names—are likely to miss on earnings or at least disappoint. While not the current situation, a potential scenario of weakening fundamentals combined with expensive valuations is probably not a good recipe for strong stock returns. Where can investors turn to address these concerns?
One potential solution can be found with the S&P 500® Dividend Aristocrats®. The Aristocrats are a collection of stocks that have grown their dividends continuously for at least 25 consecutive years and have historically demonstrated hallmarks of quality like stable earnings, solid fundamentals, and strong histories of profit and growth. Stocks like the Aristocrats are arguably well positioned to continue to consistently deliver the earnings growth “fuel” that many are looking at to drive future market returns.
The Aristocrats are also trading at the cheapest valuation levels relative to the S&P 500 in over a decade. While investors often pay a premium for quality stocks like the Aristocrats, causing them to trade at higher valuation levels when compared to the S&P 500, today’s situation is much different. Relative to the S&P 500, the Aristocrats currently trade at roughly 80% of the market’s P/E valuation. This is the cheapest level the Aristocrats have traded since March 31, 2010. The Aristocrats went on to outperform the S&P 500 over the subsequent 1-, 3-, and 5-year periods, indicating that today’s margin of safety may be an opportune entry point.
Bloomberg. Date from June 30, 2005 to June 30, 2021
The narrative of the great value rotation away from growth stocks was in full swing in the first part of 2021, until it wasn’t. Value stocks (measured by the S&P 500 Value Index) outperformed growth stocks (S&P 500 Growth index) during the first quarter by 9%. However, Q2 brought a rather unexpected reversal as momentum and growth style stocks—including technology stocks—reasserted their leadership. Maybe growth hasn’t quite been left for dead.
Growth and technology stocks’ struggles in the first part of the year are commonly pinned on rising rates. The rising interest rates that peaked in mid-February were a reminder of the perils of “growth at any price.” As the 10-year Treasury yield moved from 91 bps to 174 bps during the first quarter of 2021, technology stocks underperformed the S&P 1500 broad-market benchmark. Generally speaking, the most expensive technology stocks—as measured by price-to-earnings ratios—underperformed the most. In contrast, it was the least expensive decile of tech stocks that performed the best, up over 22% on average for the quarter.
The lesson? Investors should be thoughtful in how they execute their technology allocation. “Growth at the right price” can be a potential answer for investors looking to allocate to the increasingly important and dominant tech sector while minding the potential interest rate risk that can appear in their equity portfolio. The S&P Technology Dividend Aristocrats®, which require at least seven years of consecutive dividend growth, are another example of a group of quality companies with profitable business models and solid cash flows that are trading at reasonable valuations.
Source: FactSet, as of 5/31/21.
Many bond investors remain disappointed in the returns generated by the aggregate U.S. bond market, which was down -1.60% during the first half of the year as tracked by the Bloomberg Barclays US Aggregate Bond Index. This is despite a recent stabilization of the 10-year Treasury yield as well as a continued tightening of credit spreads, both of which helped to support the bond market during the second quarter. Shorter duration strategies, as well as those that rely predominantly on credit risk, make up the majority of fixed income segments that were able to eke out positive returns on a year-to-date basis.
Inflation-adjusted, or “real,” Treasury yields have a long way to go before entering positive territory after having been negative across the curve for most of 2021. In fact, data from the Department of the Treasury indicates that the 30-year tenor is the only Treasury yield to have crossed into positive territory during 2021 thus far. And with the recent uptick in inflation, we have seen short-term real yields fall even further into negative territory.
Negative real yields are helpful in that they support economic expansion, but it is unlikely that they will remain negative for an extended period of time. It will take a substantial rise in nominal yields in order to counteract the impact from inflation to bring them into positive territory, even if longer-term inflation averages 2% and the recent uptick is only transitory.
Diving back into the “transitory or persistent” discussion, June Fed meeting minutes indicate that 13 out of 18 members of the Federal Open Market Committee (FOMC) reported upside risks to the Fed’s preferred measure of inflation, core PCE. This compares with five members reporting upside risks in March and only one in December. As mentioned previously, TIPS can help investors hedge against inflation risk, but they carry a not insignificant amount of interest rate risk. The Bloomberg Barclays US Treasury Inflation-Linked Bond Index, which measures the performance of TIPS, has a duration of 7.6 years. This indicates that if interest rates were to rise 1%, TIPS could fall by 7.6%. As mentioned previously, 2022 consensus estimates are for the 10-year Treasury to reach 2.2%, or 70 bps above current levels.
We’ve seen the Fed become more hawkish as of late, with the majority of FOMC members now forecasting at least two rate hikes in 2023. Median projections for the Fed Funds rate longer-term stands at 2.5%. And with the Fed now talking about tapering, several potential catalysts exist to send interest rates higher. With this in mind, the trend seen in the first half of the year is likely to persist with respect to fixed income performance. As such, investors may find it prudent to access the interest rate risk within their portfolios and evaluate the solutions available to mitigate this risk. These types of solutions include short duration strategies, floating rate strategies, and interest rate hedged strategies. To learn more about these solutions, check out our recent piece on bond strategies for rising rates.
Source for data and statistics: Bloomberg, FactSet, ProShares
The different market segments represented in the performance recap charts use the following indexes: U.S. Large Cap: S&P 500 TR; U.S. Large Cap Growth: S&P 500 Growth TR; U.S. Large Cap Value: S&P 500 Value TR; U.S. Mid Cap: S&P Mid Cap TR; U.S. Small Cap: Russell 2000 TR; International Developed Stocks: MSCI Daily TR NET EAFE; Emerging Markets Stocks: MSCI Daily TR Net Emerging Markets; Global Infrastructure: Dow Jones Brookfield Global Infrastructure Composite; Commodities: Bloomberg Commodity TR; U.S. Bonds: Bloomberg Barclays U.S. Aggregate; U.S. High Yield: Bloomberg Barclays Corporate High Yield; International Developed Bonds: Bloomberg Barclays Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced.
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Bonds will decrease in value as interest rates rise. International investments may also involve risks from geographic concentration, differences in valuation and valuation times, unfavorable fluctuations in currency, differences in generally accepted accounting principles, and economic or political instability. In emerging markets, many risks are heightened, and lower trading volumes may occur. Small- and mid-cap companies may lack the financial and personnel resources to handle economic or industry-wide setbacks and, as a result, such setbacks could have a greater effect on small- and mid-cap security prices.
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