The most recent run-up in US Treasury yields – the 10-year benchmark bond yield peaked at 3.03% on 25 April 2018, though it had fallen back to 2.94% by 4 May – and the lacklustre performance of US equities, have renewed worries about the stock market outlook in face of rising rates and thus higher financing costs.
Many equity investors worry that with price-to-earnings and price-to-sales multiples still at elevated levels, they could see multiple compression even if earnings growth remains good. The price-to-next-twelve month earnings ratio on the S&P 500 index is at around 16.8x and price-to-sales at around 2.1x, which is well above the long-run averages for both ratios.
The performance of the stock market this year, as yields have swung between 2.4% and 3.0%, has differed depending upon the sectors and their sensitivity to changes in interest rates. It is illustrative to separate the market into three parts:
- Tech+ (which removes the internet retail & marketing sub-industry from consumer discretionary and adds it to information technology)
- “Bond proxies” (consumer staples, healthcare, telecom services, utilities and real estate). These sectors have benefited most over the life of quantitative easing (QE) by offering relatively high dividend yields relative to fixed income and have conversely suffered as rates have slowly normalised.
- Cyclical-‘minus’ (energy, materials, industrials, consumer discretionary excluding internet retail & marketing, and financials).
The weights of the three groupings are 30%, 28%, and 42% respectively of the S&P 500.
Rising rates: how might the market evolve?
While there have certainly been other factors driving equity index returns recently (notably the threat of a trade war with the US taking on the rest of the world), the pattern of returns gives us clues as to how the market may evolve. We can separate the time since 24 January into three periods (see Exhibit 1):
- “Rising rates 1”, from 24 January to 21 February when the 10-year yield rose by 29bp to 2.94%.
- “Falling rates”, the period to 2 April 2018 when rates dropped by 21bp to 2.73%.
- “Rising rates 2”, the period through to 25 April 2018 when rates moved up again by 30bp, peaking at 3.03%.
Exhibit 1: S&P 500 absolute total returns and relative sector returns for three US interest-rate moves*
Note: Absolute total return for the S&P 500, relative returns for the sector groupings. *Rising rates 1, 24 January-21 February 2018. Falling rates, 21 February-2 April 2018. Rising rates 2, 2-25 April 2018. Source: FactSet, BNP Paribas Asset Management, as of 04/05/2018
The first thing to note is that, despite the perception that equities have been struggling, the market actually gained 2.3% in the third period when rates were rising in contrast to a loss of 4.6% in the first period.
The bond proxies performed as one would expect, underperforming the market in both periods of rising rates and outperforming when rates declined.
The component sector returns, however, have been more varied. All five sectors had negative total returns during Rising rates 1, while during Rising rates 2, healthcare, telecom services, and utilities have posted positive returns, driven partly by robust M&A activity.
Rising rates: cyclical sector performance
The performance of the cyclical sectors has not been correlated with interest rates, as one would expect, underperforming whether rates were rising or falling in the first two episodes, while outperforming more recently. The difference is likely because the latest episode of rising rates has occurred during what has been a very strong earnings season.
Though positive earnings surprises have resulted in little relative outperformance for the stocks concerned, the good overall earnings gains (over 20% year-on-year, admittedly a figure enhanced this quarter by tax cuts), has not gone entirely unnoticed.
The sector with the most volatile performance has been technology, which has been hit by the threat of more regulation globally, more taxes in Europe and the possibility of a disruption to both its sales and its supply chains if the trade dispute between China and the US escalates.
While prices have consequently suffered, there is little apparent impact on analysts’ earnings estimates as revisions continue to outpace those for the rest of the market (see Exhibit 2). The most obvious change has been in valuations: they have fallen although earnings are being revised upward. We believe most of the long-term positive drivers for the sector are intact. If trade tensions do not result in tariffs on companies in the tech sector, this earnings trend should ultimately benefit stock prices.
Exhibit 2: Next-twelve-month earnings estimates revisions
Source: FactSet, BNP Paribas Asset Management, as of 04/05/2018
Can we expect rising rates?
The driver of performance for the bond proxies should continue to be US interest rates. We do not, however, expect rates to rise significantly through the rest of the year. We expect the yield for 10-year Treasuries will end up at between 3% and 3.25%.
Several factors would support further increases in rates:
- rising inflation
- additional increases in the fed funds rate
- the concurrent running-off of the Federal Reserve’s balance sheet.
These factors, however, should be offset by sustained tensions with China and Europe over trade, even if an actual trade war is avoided. This suggests the bond proxies will lag the rest of the market, but not necessarily generate negative returns.
This drag from higher rates, however, will probably hurt the performance of US equities relative to other developed markets (where interest rates are not rising), given that these sectors represent 28% of the S&P 500 market cap.
We believe the outlook for these sectors is still positive as economic growth in the US remains strong, consumer sentiment is buoyant and companies are using funds from tax cuts to increase business investment, reduce leverage, raise dividends and/or boost buybacks. While valuations are indeed above average, we do not believe this will be a key determinant of market movements in the medium term, until, that is, the US economy is much closer to a recession than it is today.
The final reason for us to believe that the market can withstand slowly rising interest rates is that, historically, there is little correlation between changes in interest rates and equity prices when the economy is expanding (Exhibit 3).
Exhibit 3: US equities and changes in bond yields (one-month change)
Note: data weekly from 1999 except real yields from 2003. Source: Bloomberg Barclays, Federal Reserve Bank of New York, BNP Paribas Asset Management, as of 16/02/2018
How can the low correlation be explained?
The typical explanation is that there are offsetting factors. On the one hand, higher rates mean higher financing costs for companies. On the other hand, if rates are rising because growth is strong (and not rising to reduce inflation), which is the case today, then economic growth should mean higher corporate profits.
One should not forget the experience of 1994; fed funds rose by 250bp and 10-year Treasury yields by 200bp, but the S&P 500 still posted (modest) gains for the year. We anticipate much smaller moves in rates over the next 12 months.
Equity markets often shudder when rates move up quickly and interest-rate sensitive sectors in particular suffer, but interest rates are not likely to continue to rise at the recent pace and we believe they will end the year at a level not significantly above where they are today. Since most of the other drivers of stock market prices are supportive, equity investors should not lose faith.
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