Reflation and rotation

Rising US Treasury yields moved center stage last week, interrupting the global equity rally and prompting further rotation out of growth stocks into value and cyclicals. Nominal 10-year US yields rose 11bps to end the week at 1.46%, and at one point reached 1.61%. The S&P 500 fell 2.4% and the Nasdaq 4.9%.

In our latest CIO monthly letter, “Spike train,” we argued that notable changes in key variables—the COVID-19 pandemic, fiscal stimulus, and inflation—meant that investors should expect periodic spikes in market volatility. Events over the last week show that this dynamic continues to play out.

Congress is closing in on a new fiscal stimulus package, with the House of Representatives passing President Joe Biden’s USD 1.9tr proposal on Friday. Senate negotiations may trim the size of the package, but we expect it to be between USD 1.5tr and USD 1.9tr. There are signs that the labor market is recovering—US initial jobless claims fell to a three-month low last week. Falling hospitalization rates and the rollout of COVID-19 vaccination programs have added to optimism about economic normalization and the recovery. This more positive growth outlook, in combination with signs of a spike in inflation this spring, has pushed both nominal and real US yields higher.

But we do not expect the rise in yields to derail the equity rally, as it reflects an ongoing reflation trade: 

1. Historically, rising nominal yields and equity rallies have tended to go hand in hand. In the past 25 years, there have been 10 periods in which the US 10-year bond yield has risen by more than 100bps, and in all instances global equities have delivered flat or positive returns. Rising real yields are being driven by a stronger growth outlook. What is important is why real yields are rising. Current conditions appear similar to 2016, i.e., stimulative policy leading to higher growth expectations rather than a monetary policy tightening scenario (such as the 2013 taper tantrum). The Fed has made it clear that it won’t be tightening policy anytime soon. Last week Federal Reserve Chair Jerome Powell reiterated that interest rates will remain low and that the Fed’s USD 120bn monthly asset purchases will continue “until substantial further progress” has been made toward its goals of maximum employment and 2% inflation, which are still “a long way” away. Equity valuations are not excessive relative to interest rates, even after today’s move. With 10-year bond yields at c 1.45%, the implied equity risk premium remains above 300bps. This is still within the 285– 470bps range for the equity risk premium since 2015.

As such, in our view it is the pace of the recent rise in yields, rather than the level, that has created volatility. In the period since the global financial crisis, a greater-than-40bps rise in US 10-year real yields in one month has been associated with weaker or negative equity returns. US real yields are up 32bps since the recent low on 10 February. As equities adjust to the new backdrop, we should expect a period of higher volatility.

It is also important to put the recent equity decline into context. US and global equities reached record highs earlier in February and despite the late sell-off delivered positive returns for the month. Global equities have returned 1.9% year to date. Consistent with our view that this latest setback for stocks is a volatility spike, rather than a fundamental shift in the market outlook, we recommend the following courses of action:

Go cyclical for the recovery. Last week’s fall in stocks was driven more by repositioning out of secular growth stocks, and the speed of the move caused broader market disruption. We believe this rotation has further to go and recommend investors tilt their equity exposure toward stocks that are likely to benefit from higher growth and a steeper yield curve, including financials, industrials, and energy stocks. Read more here on going cyclical for the recovery.

Take advantage of volatility. Pullbacks in the market offer investors who are overexposed to cash the opportunity to put capital to work in the market in the context of a disciplined financial plan. This includes averaging-in purchase programs, structured investments, and, for investors who can use them, option strategies. Sharp sell-offs in the market are often accompanied by moves in volatility that offer opportunities to gain more advantageous market exposure through options. Click here for more on taking advantage of volatility.

Mark Haefele

UBS AG