Rising bond yields, slowing stock momentum: what to do?

As bond yields are soaring, momentum on stock prices is slowing down. Is this the end of the party? While the situation may look grim, we ought to have a closer look at it to see that things might not be as bad as they seem.

Key takeaways

  • The yield on the US 10-year Treasury note has risen to 1.4320%, their highest in a year.
  • However, even this rise in bond yields should not be enough to spoil the appeal of stocks over bonds.
  • Tech, consumer discretionary and industrial sectors tend to be the best performing sectors of the S&P 500 in a rising rate environment.
  • When looking at the historical performance of the S&P 500, we can notice that equities usually perform above average when inflation stands between 1 and 4%.
  • A higher bond yield might be a sell signal for long-term investors.

 

What is happening?

Rising Treasury yields are sending shivers through the stock markets, investors tend to get cautious and many have started to sell off their stocks. The yield on the US 10-year Treasury note has risen to 1.4320%, which is about the highest in a year. Yields in general are seeing their highest weekly rise in six weeks.

 

Rising bond yields

 

The rise of bond yields is largely blamed on expectations of a surge in inflation, which would be the result of high government spending and loose monetary policy.

 

3 reasons why the stock market can survive rising bond yields

However, even this rise in bond yields should not be enough to spoil the appeal of stocks over bonds. we ought to have a look at what stocks are offering in terms of dividends and earnings yields relative to bonds. We should also observe which bond moves caused troubles for equities. After a close examination, things do not look so bad for the year.

Dividend yield

To examine dividend yields, we can measure the percentage of stocks in the S&P 500 that keep exceeding the 10-year Treasury yield. While we must notice that the percentage has fallen from 64% to 51.5%, it’s still high enough, usually followed by a 17% gain for the S&P over the following 12 months according to RBC Capital Markets

Earnings yields

The S&P 500’s earnings also went down, standing at a level last seen in 2017-2018. However, this is nothing but a short-term pull back, as it stays in range of the 9.3% average gains by the S&P 500 over the next 12 months. Long term investors should therefore not fear for their investments, as the downtrend is not expected to be sustained. This situation contrasts with what happened in 2018, as back then, the trade war was a significant threat to the US economy, while today, we are seeing gross domestic forecasts going up.

Treasury yields and stocks

US equities tend to struggle when the 10-year yield rises more than 2.75 percentage points. It would have to go up to 3.26% to reach such a critical level. However, the yield now sits at 1.4320%, meaning that there is much room before such a level is reached.

 

Additional proof from history: tech and cyclical stocks

Although past performance can never guarantee future returns, it is always interesting to have a look at history to identify repeating schemes. Indeed, it seems that when yields are rising “for the right reason”, cyclical stocks and tech stocks should not fear and tend to thrive in the long run.

When bond yields rise to improve economic growth and a healthy – moderate – rise in inflation, this is what we call right reasons.

What we can notice is that tech, consumer discretionary and industrial sectors tend to be the best performing sectors of the S&P 500 in a rising rate environment. This could suggest that selling off your favourite tech and cyclical stocks might not be the best way to play this situation.

 

 

Average performance of sectors relative to S&P 500 in rising rate environment

Average performance of sectors relative to S&P 500 in rising rate environment

 

Beyond surviving, is it an opportunity to buy the dip?

It might be. If inflation does come to happen, it may be a welcome development for stock market bulls. Indeed, when looking at the historical performance of the S&P 500, we can notice that equities usually perform above average when the inflation stands between 1 and 4%.

This is what we call a healthy level of inflation if it coincides with economic activity – which it probably will, as the post-pandemic world will start to reopen. Companies have pricing power, meaning they can afford to raise prices, and they can also profit from productivity gains, boosting earnings growth. These factors generally push the stock prices up.

We also need to note that Covid-19 cases are going down – below 50,000 this week – which could be a great signal of confidence for the economy and stocks in general.

The boost in retail traders – notably millennials – investing in stocks, is also a great optimism provider for stocks. Bonds remain less attractive in terms of returns, especially if inflation is to be expected. Lastly, the VIX volatility index is declining, which historically, is a sign for larger equity gains.

 

How to play it

There are a few opportunities to play your confidence in stocks, one of which is to invest in ETFs tracking the best performing sectors of the S&P 500 in a rising rate environment, such as:

 

 

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