Stableford Capital—February 2021 Review: Why Rates Matter
After reaching all-time highs in mid-February, equity markets have started to decline and become highly volatile. What is driving this? The back-up in yields as the 10 Yr. U.S. Treasury moved from 1.09% to 1.41% during February (Figure 1).
Rates Rise in February
Our long-time readers will recall that yields like the widely quoted 10 Yr. U.S. Treasury are quoted in nominal terms. Nominal yields have two components, real yields, and inflation. While inflation started to move first, lately real yields have begun to increase, indicating investor anticipation of real future economic growth (i.e. not just inflation-driven pricing). The Corona recovery coupled with upcoming reconciliation-bill stimulus are the drivers of this (hey, even bond markets will wake up for $1.9 Trillion). Fixed-income investors are now demanding to be compensated for the higher growth rates in the form of higher interest rates on their principal.
As real yields move higher, the future earnings of equities are worth less than at lower rates (recall equity prices are simply the current value of an expected future earnings stream discounted to today—dividing by a bigger denominator means a lower value). And the equities with the highest expected future growth (i.e. biggest proportion of earnings further out in the future and highest current valuations) are affected the most. This is why many of the growth-driven tech names in the NASDAQ are down so much. Through early March the NASDAQ Composite is down 10.5% from its highs compared with -2.8% for the S&P 500.
Equities Feel the Rate Move Impact
So, what does all this mean for equities? A HUGE rotation between sectors. While the S&P 500 was up 2.6% in February, it is masking the underlying moves within sectors and the aforementioned NASDAQ vs S&P 500 performance. For example, as higher valuation equities are dropping in value, cyclical areas that benefit from a rebound in economic growth such as banks are becoming more valuable. This rotation causes a great deal of angst and uncertainty as investors reset their expectations. Angst and uncertainty lead to volatility and wild gyrations as investors move out of highly valued areas and into value and cyclicals as we have seen in the latter half of February and the beginning of March (Figures 2 – 3).
February +2.6% SPX Returns Mask the Underlying Changes
Such as NASDAQ Underperformance From the Highs through March 8th
And how is Stableford positioned for this? Our largest overweight positions since the start of this year have been in cyclical areas such as energy (oil rebound) and banks, as well as real estate (tenants return as the economy opens back up). Tech has been the most underweighted area.
In terms of fixed income, we have been underweight fixed-rate investments (as rates go up, principal declines) in order to avoid losses on principal.
The sector rotations and volatility are likely to persist for some time. However, the downside is probably limited as Fed Chair Powell will likely change the rhetoric if things get too volatile. Look for a “Powell Put” news story in the next few months should things get out of hand. The Fed still has some weapons in its arsenal such as yield curve control, or pinning the 10 Yr. U.S. Treasury to a price such that rates won’t increase.
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This market commentary was written and produced by Stableford Capital, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 INDEX: The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.