Stocks Fall Even as Yields Spike
Stocks fell again last week amid more mixed economic data releases and a sharp increase in bond yields. The Dow Jones Industrial Average dropped 0.89% to 17,849, the S&P 500 Index fell 0.71% to 2,092, while the Nasdaq Composite Index held up better, slipping only 0.04% to 5,068. Meanwhile, the yield on the 10-year Treasury rose sharply from 2.12% to 2.40% as prices correspondingly fell. Indeed, although last week featured multiple signs that global growth remains sluggish, this did not stop bond yields from hitting fresh highs for the year. While the year-to-date rise in yields has been modest, parts of the market sensitive to rate increases have still proved vulnerable. For investors looking to ride out this change in the rate regime, we’d look at financial and health care stocks.Gyrations in Bond Markets
Last week confirmed what many investors already suspected: Global grow this unlikely to accelerate this year. Evidence included a 10% plunge in cyclically sensitive South Korean exports, a markdown of global growth estimates by the Organization for Economic Cooperation and Development, weak U.S. factory orders and a tepid read on the U.S. economy by the Federal Reserve (Fed).
But there were some positives as well, mostly in the United States: a strong manufacturing survey from the Institute for Supply Management, a 280,000 increase in net new jobs in May and a modest acceleration in wage growth.
Despite the mixed messages, bond yields resumed their ascent. In the U.S., this is partly a function of shifting expectations around the date of the Fed’s interest rate liftoff. Consistent with our view, investors are now seeing September as the likely date for that first fateful shift in monetary policy. However, the rise in U.S. real yields—now up by more than 50 basis points (0.50%) since mid-April—still seems severe in an environment characterized by uninspiring growth. Part of the explanation lies in the fact that European bond yields, which have experienced a similar surge, are no longer anchoring global yields to the same extent they did a few months back.
Our view is that these gyrations in the bond markets are being driven primarily by technical factors as well as investors selling European debt, a reversal of what has been a massively crowded position. Still, while volatility is likely to continue, over the intermediate term the rise in bond yields should be contained by demand from investors, particularly pensions and insurance companies, who are still desperate to source yield.
Rate-Sensitive Sectors Most Vulnerable
Unfortunately, even if you assume bond yields settle down, probably somewhere in last fall’s range of 2.20% to 2.60% for the 10-year Treasury note, this is still likely to inflict significant damage on parts of the market.
In addition to long-duration Treasuries, investors also need to consider that some of the classic “safe haven” plays may not be as safe as advertised. These include high-yielding defensive equities like utilities, as well as precious metals, both of which are sensitive to changes in real interest rates. Last week U.S. utilities, usually viewed as a less risky sector, were down 4%, dramatically underperforming the market. The sell-off was a function of investors re-pricing the sector in accordance with higher rates.
Precious metals were another casualty of last week’s bond market rout, with gold and silver down 1.50% and 3.50%, respectively. Their weakness relative to stocks, and even other commodities, was consistent with the historical pattern: These assets are very sensitive to rising real rates.
With some of the classic safe havens like precious metals and less risky stocks providing little protection, we believe investors should consider some less obvious places for that ballast. One is the financial sector, with banks a potential beneficiary of higher rates. Despite broader stock market weakness, the S&P 500 financial sector was actually up last week. For investors looking at more defensive parts of the market, we’d prefer health care stocks to utilities or telecommunications. Unlike the latter two, health care generally performs relatively well in a rising-rate environment.
Russ Koesterich, BlackRock
