Wall Street Bull statue in New York’s financial district.
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Rising interest rates can set off the alarm in the stock market, but strategists say be prepared without fear.
Currently, interest rates are rising with the idea that inflation will rise too.
But the alarm right now is probably more like a smoke alarm and a burned pan than a house on fire.
“This is less about the absolute level of returns than the speed at which we can get there, and at this point we are not concerned with speed,” said Julian Emanuel, chief strategist for stocks and derivatives at BTIG.
The most closely observed rate of return is the benchmark 10-year Treasury, which affects mortgages and other loans.
It was lower at 1.16% on Tuesday after hitting the key 1.2% on Monday. At this level, strategists say it would be headed towards 1.25% which could trigger another pause higher. At the end of January, the yield, which moves against the price, hit a low of 1%.
Returns on the way up
Bond professionals say yields are higher and rising for a number of reasons.
A major factor is Covid’s fiscal incentives, the $ 900 billion approved in December and the $ 1.9 trillion plan now floating through Congress.
Better growth is expected due to federal money, but this also leads to more debt and possibly inflation. That’s another reason for higher yields.
BTIG’s Emanuel said he was concerned if the 10-year rate of return rose higher. He expects 1.7% by the end of the year.
However, if it moved too fast, stocks could reach a tough point. For example, a danger zone would be around 1.34% if the 10-year return hit that level this month.
“That would likely be a headline that would limit the rise in markets and cause further rotation away from high multi-growth stocks to cyclicals and value,” said Emanuel.
“Cyclicals in particular could absorb this type of rotation and move the market sideways,” he added. “The same speculative interest that the public has shown in tech stocks … it’s entirely possible that sometime in 2021 you’ll get some level of speculative zeal that you’ve seen in these guys as you head towards financial stocks . “
The S&P financial sector has grown by around 6% since the beginning of the year.
The banks have risen as the yield curve has steepened. This simply means that the difference between short-term interest rates like the 2-year interest rate and longer-term interest rates like the 10-year interest rate has increased.
This so-called steeper curve helps banks make money because they can borrow at very low short-term interest rates and borrow at higher interest rates for longer periods of time.
Bank of America strategists say energy and technology hardware are among the expensive sectors that could be hurt by rising interest rates. Banks, diversified financials and semiconductors are among the low-cost sectors that benefit from rising interest rates, they added.
Stock dividends versus yields
However, strategists say that while government bond yields are rising, they are far from rivaling stocks for investment dollars.
Lori Calvasina, head of US equity strategy at RBC, said there isn’t a set level at the 10-year level that is a negative trigger for stocks, but “3% feel that people in the past were more likely to were concerned. “
Calvasina said she was watching the number of companies in the S&P 500 paying dividends above the 10-year yield. At the start of the year, 63% of the S&P 500 companies had dividends above the 10-year return and 56% a few weeks later.
“If it falls to 20% or 30%, the market could start struggling at that level,” she said. If the market doesn’t get into trouble at this point, there will still be problems and investors will see a lower forward yield.
Trading on rising interest rates and inflation is to a large extent the rotation of value cycles that began in the second half of last year as vaccine news was positive and investors looked forward to a more normal economy in 2021.
Inflation expectations have risen but are still low.
The 10-year breakeven point, which is a market-based measure of inflation, was 2.20% on Tuesday, down from around 2.1% early last week. This means that investors are betting that inflation will average 2.2% over the next 10 years.
RBC’s Calvasina said if rates rise and inflation expectations rise, investors should stick with reflation trading.
The reflation trade is when investors bet on companies that do well when the economy improves and opens again. This includes airlines, financial and industrial companies.
Calvasina also said she likes the financial sector, but some investors misconceive that parts of the reflation trade are already branded in.
Energy may have risen more than 15% with the rise in oil prices this year, but other cyclical sectors such as materials and industries have only increased about 2% since early 2021.
Growth areas in technology and communication services could be used as a source of funding for the rotation as they have done well, Calvasina said.
“When inflation expectations rise, you tend to see the underperformance of technology, the underperformance of communications services. The parts that do well are raw materials and finances,” she added.
Jonathan Golub, chief US equities strategist at Credit Suisse, doesn’t expect technology to be unduly affected when interest rates rise. But the stocks that have to be bought in this environment belong to the “junkiest”.
“I don’t think the technology will be stifled. I think the better view is who will get the most out of an improving economy. The answer is cyclical companies … and companies that have a business problem,” he said. “They want someone on the brink, a smaller cap, companies that have a lot of debt.”
Golub also said that rising government bond yields are also positive for the market as they represent an improving economy.
“The most stimulating event in the history of the planet will not be the end of World War I, the end of World War II, but the reopening of the economy this summer,” he said.