October 2021
Interest Rates Are Rising. What’s the Impact on Equity, Fixed Income and Other Markets?
KEY OBSERVATIONS

Interest Rates Are Actually Rising—Now What?

October’s biggest news story was the dramatic jump in treasury yields. The 10-year Treasury jumped nearly 20 basis points (bps)—driven by a Fed meeting that seemed to bring tapering one step closer, and perhaps even accelerated the timeline to a rate hike as well. While the debate continues over just how transitory current inflationary pressures are, keep in mind that those treasury yields could rise even without any inflation. The long-term average treasury yield is roughly 4%—comprised of—on average 2% inflation and a 2% real yield. It is precisely the point of quantitative easing to suppress longer-term bond yields, and it is precisely the point of tapering to allow them to normalize. A normalization of the 10-year treasury’s real yield would put the yield at 2% with zero inflation, and 3% with just 1% inflation.

Is Stagflation Worth Discussing?

Meanwhile, dramatic scenes of cargo ships waiting interminably to be unloaded outside of Southern California, New York and New Jersey, combined with rising energy prices, has brought stagflation back into the lexicon. A stagflation scenario—where a protracted supply shock simultaneously drives up prices and drives down growth—seems unlikely. Witness the last very strong U.S. durable goods report, or the last quite strong retail sales report. Even if supply chain challenges are measured in quarters rather than weeks, damage to the economy is likely to be minimal. And any positive news with regard to the Delta variant will likely have the double benefit of spurring additional demand and resolving some supply chain issues.

While stagflation may be quite unlikely, rising interest rates, and at least a bit of inflation (average hourly wages—the “sticky” stuff—rose 4.3% year-over-year as of the August payroll report), seem very likely. The equity markets have reacted accordingly. Cyclical companies that can benefit from a near-term old-fashioned recovery outperforming of late.

Small Caps Provided Surprising Outperformance

However, let’s focus on perhaps a little bit of a surprising development. Small-cap stocks outperformed the S&P 500 right after the Fed meeting through the end of the month. Was it the sector composition (a bit less tech and a bit more cyclicals)? Is small cap a great late-cycle play (as if we know where we are in a pandemic-interrupted business cycle…)?

A better bet might simply be valuations. Small caps are cheap after years of underperformance. But what’s the surprise? Another piece of conventional wisdom is that small-cap stocks are sensitive to rising interest rates. Why? They’ve got a lot more leverage than large caps, and thus are more exposed to increasing coupon payments on their debt. There’s some evidence that those two opposing small-cap forces—cheap but leveraged—were in play last month. The Russell 2000 Dividend Growth index dramatically outperformed not just large-cap stocks but the Russell 2000, returning over 2% post the Fed meeting. And guess what—those Russell 2000 Dividend Growers—in addition to having consistently grown their dividends historically, have less leverage than the S&P 500.


CHART OF THE MONTH:
Small Caps May Be Prudent—With Less Risk and Less Leverage

Returns Since the Fed Meeting
Returns since the Fed Meeting
Price-to-Book
Current Price-to-Book Ratios
Total Debt to Total Assets
Net Debt to EBITDA

Source: Bloomberg. Returns shown are from 9/22/21 - 9/30/21. Price-to-book and total debt-to-total assets are as of 9/30/21. Net debt to EBITDA ( earnings before interest, taxes, depreciation, and amortization) 2021 year-end estimate. Price-to-book value is the ratio of the price of a stock (or index) versus book value per share.


PERFORMANCE RECAP

Rising interest put stocks and bonds in the red for the month of September. U.S. Large Cap Growth suffered the most as investors questioned whether growth could overcome the impact of higher-equity discount rates implied by higher interest rates. Only commodities stayed in the green, driven in part by oil, which rose roughly 10%.

Returns of Various Common Market Segments

Market Segment Returns—September 2021
Market Segment Returns—September 2021
Market Segment Returns—YTD
Market Segment Returns—YTD

Source: Bloomberg. September returns 8/31/21‒9/30/21, year-to-date returns 12/31/20‒9/30/21. Performance quoted represents past performance and does not guarantee future results.



Economic Calendar

Here’s a list of upcoming key economic releases, which can serve as a guide to potential market indicators.



Equity Perspectives
Technology Stocks Face a Rising-Rate Challenge

The recent government bond yield backup introduced volatility in the equity markets during the last week of September. Among the hardest hit sectors was technology, which saw its shares decline 5.8% (S&P Technology Select Sector) for the month, slightly worse than the S&P 500. The explanation often given for tech-stock sensitivity to rate moves centers around the timing of earnings and cash flows. When rates are lower, the logic goes, investors are willing to ascribe a higher value to technology shares that they expect will deliver outsized profits far out in the future. Conversely, rising rates can cause investors to discount the present value of those faraway profits, and shares often fall.

A similar pattern happened during Q1, when rates rose sharply and technology shares pulled back. Although the Q1 pullback was temporary, this time around may be different given the Fed’s indication that tapering may soon begin. But here’s the rub: Tech shares should not all be painted with the same brush. While there are plenty of growth and technology names with little to no current profits, many are producing robust profits and cash flows today. And a select few companies are turning these profits into a growing shareholder yield. Using a simple screen like consistently growing dividends can quickly separate the wheat from the chaff.

Follow the Cash: Technology Stocks Are the Market’s Biggest Dividend Payers

Technology stocks have come a long way in the last decade in terms of dividends. As recently as 10 years ago, relatively few technology companies even paid dividends, much less grew them. In fact, only 1 in 4 tech stocks paid a dividend in 2011. Tech investors today don’t have to wait for future profits to materialize to be paid. The biggest dividend payer on the planet is Microsoft, which paid over $16.5 billion in dividends in its last fiscal year. Apple, which paid over $14 billion in dividends, is the fourth-largest dividend payer. Taken together, technology stocks currently pay almost $86 billion in dividends, making them the biggest dividend payers of any sector in the S&P 500. And tech stocks continue to grow their dividend at the fastest rate of any sector.

Technology Stocks Are the Biggest Dividend Payers in the S&P 500

Technology Stocks are the Biggest Dividend Payers in the S&P 500

Source: FactSet. Data as of September 30, 2021.


Most recently, Microsoft raised its quarterly dividend to $0.62 per share, representing an increase of over 10% from the prior year. Its dividend has doubled since 2014. Perhaps the most exciting part of the story is that Microsoft’s dividend growth appears to be just getting started. Its current dividend payout ratio of just 27.8% compares favorably to the average S&P dividend payer with a payout ratio of 32.4%. Microsoft is generating almost $7.50 per share in free cash flow even after paying the dividend. This cash flow machine is rewarding its investors today and is well positioned to potentially deliver plenty of future dividend increases.

The Technology Dividend Aristocrats

While Microsoft and Apple are certainly dividend heavyweights, they are by no means alone. The S&P Technology Dividend Aristocrats currently comprise 36 companies that have grown their dividends for at least seven consecutive years—a potentially compelling opportunity for dividend-focused investors. The S&P Technology Dividend Aristocrats® may also be uniquely positioned to address today's challenges for investing in the technology sector. Bargains may be hard to find in a fully valued market, but they are out there if one knows where to look. The Technology Dividend Aristocrats currently trade at significantly lower valuations than the overall technology sector.


Technology Dividend Aristocrats Are a Relative Bargain

Technology Dividend Aristocrats Are a Relative Bargain

Source: FactSet Data as of September 30, 2021. P/E= Price to Earnings.


Fixed Income Perspectives
Where’s My Safe Haven?

Despite the majority of risk assets posting negative returns in September, Treasury bonds, often known as a safe haven for investors, were down for the month as well. In the past we’ve discussed the suboptimal environment for traditional fixed income strategies due to a likely normalization of interest rates. With longer-term interest rates rising, the poor performance of the Treasury market likely does not come as a surprise, as bond prices and interest rates have an inverse relationship. The 10-year Treasury yield was up 18 bps for the month and the U.S. aggregate bond market fell 0.87%, as tracked by the Bloomberg U.S. Aggregate Bond Index. Segments of the market that are shorter in duration were able to eke out positive returns for the month.

Fixed Income Segment Returns—MTD
Fixed Income Segment Returns—MTD

Source: Bloomberg



The Next Rate Hike

During the month, Fed Chair Powell indicated that many Federal Reserve members believe U.S. employment has already achieved “substantial further progress,” an achievement which the Fed previously indicated it was waiting to accomplish in order to begin tapering its asset purchase program. Could the rise in the 10-year Treasury yield seen in September be the start of the next taper tantrum? Last month we looked at what happened during the 2013 taper tantrum, when the 10-year Treasury yield rapidly rose more than 100 bps in the months following the announcement that the Fed would begin tapering. This time around the Fed seems to be taking measures to provide sufficient forward guidance in an attempt to avoid another tantrum. While interest rates may stabilize in the near term, we expect them to continue to rise longer term.

The dot-plot projections released after the recent FOMC meeting also indicated a more hawkish Fed, with half of the Federal Reserve members projecting the first interest rate hike to take place next year. While the speed at which rates rise across the yield curve may be subdued, current historically low levels are likely unsustainable. Compared to 2013, the interest rate risk embedded in the U.S. bond market has steadily increased. Corporate bonds, specifically, have extended durations when compared to the broader market.

Duration
10-year Treasury Rise

Source: Bloomberg. 5/21/2013 was the start of the 2013 taper tantrum. Duration is a measure of bond price sensitivity to a change in interest rates.


If rates continue to rise, investors would be wise to look outside of traditional corporate bond strategies to mitigate the interest risk embedded in their portfolios.

ProShares Investment Strategy Team



Sources for data and statistics: Bloomberg, Morningstar, 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 U.S. Aggregate; U.S. High Yield: Bloomberg Corporate High Yield; International Developed Bonds: Bloomberg Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced.

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This is not intended to be investment advice. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

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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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