Will Surging 10Y Yields Crash Stocks: A Q&A From Goldman
Gradually over the past few weeks, as yields have risen, TINA has mutated into TIAN – there is an alternative – in the form of 10Y yields, and the higher rates rise, the more attractive said alternative becomes when compared to the relentless decline in the dividend yield of the S&P500 which just hit an all time low.
It’s also why as yields continue to rise, the risk grows of either a controlled – or chaotic – rotation out of stocks and into bonds, and is why JPM listed rising yields (along with the stronger dollar) as a potential threat to markets although as the bank caveated, “the velocity of the move is more important than the absolute levels. An increased velocity in the move may be the market signaling that there are more problems underlying the US economy than headline numbers suggest; one problem is stagflation.”
The recent rise in yields is also why overnight Goldman, in response to mounting client worries that a spike in yields could end the market euphoria, published a Q&A on “rates and equities”, in which the bank wrote that “with the nominal 10-year US Treasury yield back above 1%, investors have been focused on the risk to US equities from higher interest rates.”
In the report, Goldman’s Ryan Hammond answered eight of the most common questions on the relationship between rates and equities, which we excerpt below:
- How has the recent rise in interest rates affected US equities?
- How vulnerable is the equity market to higher interest rates?
- Is there a “tipping point” between rates and equities?
- Which industries are the biggest beneficiaries from rising rates and which aremost at risk?
- Which styles are the biggest beneficiaries from rising rates and which are most atrisk?
- What is the impact of rates on “big tech” (e.g., FAAMG)?
- What is your baseline forecast for rates and equities 2021?
- What can the taper tantrum of 2013 teach us about the market in 2021?
We unpack each of these questions below:
1.How has the recent rise in interest rates affected US equities?
Since the announcement of Pfizer’s efficacious vaccine candidate in early November, the 10-year US Treasury yield has risen by 32 bps to 1.15%. However,over the same period the S&P 500 equity risk premium (ERP) has declined by 44 bps as investors gained confidence about the economic recovery, more than offsetting the impact of higher rates on equity valuations. On net, the cost of equity is 12 bp lower and the S&P 500 has risen by 10% since November 6. Positive EPS revisions have also supported the index. The ERP now stands at 5.7% but still remains elevated versus history.
The rise in interest rates has been driven by an increase in 10-year breakeven inflation. Breakeven inflation has risen from 1.65% on November 6 to 2.17% today, the highest level since October 2018. Higher breakeven inflation in part reflects improving investor growth expectations, which drives the ERP lower. In contrast, real rates have actually continued to decline to -1.02%, close to the lowest level post-2003.
As Goldman notes, below the surface, rising rates have led investors to pay more for stocks with the fastest near-term growth, such as value stocks and cyclicals. The bank writes that in its fundamental valuation model, equity duration (long-term growth) is the most important determinant of stock valuations. Indeed, the relative importance of equity duration rose to a record high in June 2020 when the 10-year US Treasury yield equaled just 0.6%, as the lower discount rate disproportionately benefited stocks with a large share of expected cash flows generated far in the future. However, as interest rates have risen above 1%, the importance of near-term growth for valuations has risen, while the value of long-term growth has declined. This pattern is consistent with the recent outperformance of value and cyclicals, as their earnings are expected to grow more rapidly than for growth stocks this year given their low base.
In other words, equity duration remains the most important driver of valuations, consistent with the elevated valuation multiples of growth stocks today. But the increased importance of near-term growth has resulted in relative underperformance since November
* * * * *
2. How vulnerable is the equity market to higher interest rates, breakeven inflation or real rate driven?
In the past three years, the most favorable backdrop for equity returns has been when real rates were falling and breakeven inflation was rising (like now). The average weekly S&P 500 equity return during these periods was +1.6% since the start of 2018. But returns during periods of rising breakeven inflation and rising real rates were also above-average (+0.7%) and carried a roughly similar hit rate of positive returns (74%).Put simply, returns have been more clearly delineated by the trajectory of breakeven inflation, rather than real rates, during the past three years.
Goldman then notes that the relationship between the S&P 500 and breakeven inflation has been consistently positive since 2012. In the era of low and anchored inflation expectations, fluctuations in breakeven inflation are often viewed as a reflection of shifting growth expectations and risk sentiment. Improving growth expectations often correspond with higher breakeven inflation, rising earnings expectations, and improving investor sentiment, which more than offset the higher discount rate. Empirically, a two-factor regression of S&P 500 returns on changes in breakeven inflation and real rates bears outthis relationship. Since 2018, every 1 standard deviation increase in breakeven inflation,accounting for the change in real rates, has driven a 0.6 standard deviation increase inS&P 500 returns. The coefficient was largest during risk-off events (e.g., February 2016,December 2018) and was smallest during the lead-up to the market peak in February2020.
The relationship between the S&P 500 and real rates has varied; while not a universal positive, higher real rates have not been a universal negative either (still it mean that the Fed will be aggressively buying TIPS for a long, long time). Unlike breakeven inflation, the sign of the beta of S&P 500 returns to real rates has fluctuated between positive and negative. Changes in real yields can reflect a combination of growth expectations, Fed policy, or other factors, and therefore could be a mixed bag for equities. As a result, since 2018, every 1 standard deviation increase in real yields has driven just a 0.04 standard deviation increase in S&P 500 returns on average. But looking at periods of rising real rates (excluding periods around recessions),equities have generally struggled to digest higher real rates when driven by Fed policy but have moved higher when driven by growth. Equities fared best during the reflationary periods post-election in 2016 and during the passage of corporate tax reform in late 2017 despite real rates rising at the same time. The S&P 500 fell during periods of rising rates when driven by expectations of Fed tightening such as the “taper tantrum”in 2013 and Fed Chair Powell’s comments that rates were a “long way” from neutral in 2018 (Exhibit 8). Therefore, the underlying macro drivers of rising real yields will likely dictate the net impact on equities.
* * * * *
3. Is there a “tipping point” between rates and equities?
Given the historically low level of interest rates, Goldman views interest rates as “still well below levels that would be thought of as a “tipping point” for equities.” As the bank explains, “we previously wrote about how the interplay between rates and the ERP becomes more challenging as nominal 10-year US Treasury yields approach 3.5%, well above the futures market forecast for the next few years” although given rates currently near the lower bound, “that level is likely too high of a tipping point today” Goldman concedes. Another approach is to consider the relative valuation of equities versus history using the yield gap (earnings yield less10-year US Treasury yield). That gap equals 330 bp today (4.5% EPS yield, 1.2% USTyield). Assuming an unchanged P/E, the 10-year US Treasury yield could rise to 2.0% and relative valuation would still only rank in the 50th percentile. If the 10-year UST yield rose to 2.7%, relative valuation would rank in the 67th percentile versus history, a level not seen since 2004, holding the P/E constant.
Instead, Goldman expects the speed of interest rate changes will be a more meaningful tactical driver of equities, a point we have made repeatedly in the past. The reason for that is that stocks are usually able to digest gradual increases in interest rates. However, equities typically fall on average in a given month when interest rates rise sharply, specifically two or more standard deviations in a month (which would be about 36 bps per month in today’s terms). Similarly, Goldman has also found that the equity-bond correlation typically reverses during sharp, two standard deviation moves in rates.
* * * * *
4.Which industries are the biggest beneficiaries from rising rates and which are most at risk?
S&P 500 industries can generally be categorized as cyclicals (which outperform when rates rise), defensives (underperform when rates rise), and secular (perform irrespective of rates). Defensive parts of the market, such as Utilities and Household Products have a strong negative relationship with nominal 10-year US Treasury yield, while cyclical parts, such as Banks and Autos, have a strong positive relationship. For other parts of the market, such as technology, their secular and idiosyncratic growth profiles mean that changes in interest rates are unlikely to be a major driver of returns.
Exhibit 13 provides a breakdown of the sensitivity of industry group returns with the separate components of nominal bond yields. Most industries have similar sensitivities to both real rates and breakeven inflation. Investors confident that rates will move consistently higher or lower should own stocks in industry groups in the top right or bottom left quadrants
But even a rising rate regime often includes periods of falling rates, which means the magnitude of return sensitivity to rising and falling rates separately is also key (Exhibit 14). This dynamic has been most clearly reflected in the performance of Info Tech since early November. The sector underperformed in weeks of rising rates but outperformed by more during the weeks when rates fell. On net, nominal rates rose by 24 bp but Info Tech has actually outperformed the S&P 500 by 1 pp. Investment horizon and conviction in the path of rates will play a key role in whether to tilt towards cyclicals, defensives, secular, or embrace a barbell approach.
* * * * *
5.Which styles are the biggest beneficiaries from rising rates and which are most at risk?
In periods of rising rates, growth typically underperforms Value. Based on the sensitivities of returns to real rates and breakeven inflation, equities across a variety of styles tend to rise in absolute terms during periods of rising real rates and break eveninflation. However, more cyclical parts of the market have stronger correlations with rates and therefore outperform on a relative basis. This pattern helps explain why Value rallies tend to occur during rising equity markets – because value stocks usually “catchup” rather than a growth stock “catch down”.
However, only a small share of the relative returns of Growth strategies have been explained by changes in rates, muddying the relationship. Changes in rates explain just 19% of the variation in Growth vs. Value monthly returns since 2018, and 7% of the variation in NDX vs. S&P 500 returns. This compares with a much higher 54% for Cyclicals vs. Defensives. The low explanatory power is likely because other idiosyncratic drivers matter for Growth strategies more than changes in rates. For example, the widespread adoption of technology has driven a secular rise in earnings growth, while the demand for growth in a structurally low economic growth environment has kept growth stock valuations elevated. Goldman provides a sensitivity of various thematic pairs to real rates and breakeven inflation, based on their observed relationship during the past three years in Exhibit 16. However, the magnitude of potential outcomes is particularly wide for themes where explanatory power is low (e.g., NDX vs. S&P 500, Growth vs. Value).
Once the market fully prices an economic recovery, investors will again be faced with a macro backdrop of trend US GDP growth below 2% and interest rates below 2%. While rising rates would suggest duration would become a less valuable attribute, the level of valuation for stocks should still remain elevated. A nominal 10-year US Treasury yield below 2% and trend growth around 2% have historically both still been associated with above-average valuation premium assigned to duration.
The challenges of timing and investment horizon can be seen clearly in the most recent Value rally. Since Pfizer’s announcement on November 9th, Russell 1000 Value has outperformed Growth by 6 pp. However, the majority of that outperformance occurred in the first two days post-announcement. The indexed relative performance is only back to its level from July 2020, amid new virus strains, initial vaccine roll out delays, and a reiteration of accommodative policy from the Fed (Exhibit 19).
Goldman urges investors to own long-duration cyclicals to capitalize on both the low level of interest rates and the economic recovery. The compromise strategy offers the best of both worlds, albeit with the trade-off of less extraordinary returns than pure growth stocks or cyclicals in environments specifically conducive to just one of those strategies. Long duration cyclicals outperformed Goldman’s broad cyclicals basket during the growth stock outperformance of 2020 and outperformed growth stocks during the vaccine-driven rotation since early November. However, long duration cyclicals lagged most during the positioning-driven sell-off last week, a key risk going forward.
6. What is the impact of rates on “big tech” (e.g., FAAMG)?
For four of the five FAAMG stocks, more than 70% of the return since the February peak has been driven by earnings growth rather than valuation expansion. While investors often focus on the elevated valuation multiples of FAAMG, Goldman notes that “it is notable that all five of these stocks posted positive sales (median +14%) and EPS (+24%) growth during a year when S&P 500 sales and EPS declined by 3% and 14%.” FAAMG benefited both from the low interest rates that made their high-growth cash flows more valuable, but also from business models that remained in demand during the recession. 110% of AMZN’s return, 101% of FB’s return, and 94% of MSFT’s return was driven by EPS growth. This pattern stands in contrast with some of the best-performing, smallergrowth stocks during the past year, which also carry much higher valuation multiples(Exhibit 21).
FAAMG stocks screen attractively on long-term growth, balance sheet strength, and near-term growth, the three largest drivers of valuations in Goldman’s model today. While the five largest stocks have attractive long-term and near-term growth, they are also extremely profitable and have among the strongest balance sheets in the index. These companies continue to meet elevated growth expectations, in contrast with the largest stocks in the Tech Bubble. Just last week, each of the five companies beat earnings expectations, by an average of 40%.
FAAMG’s secular growth profiles mean that changes in interest rates play a relatively limited role in explaining their returns. For macro-driven industries such as Energy or Banks, breakeven inflation and real rates can explain more than 40% of the variation in their weekly returns. In contrast, those rate components explain just 10% for the average FAAMG stock, which are defined by their idiosyncratic, secular growth profiles. Unlike the broader index, the relative returns of FAAMG have had mixed relationships with both breakeven inflation and real rates since 2012. FAAMG returns have been negatively correlated with breakevens and real rates during the pandemic recession. The sensitivity has become less negative in the past few weeks and had been positive as recently as January 2020.
7.What is Goldman’s baseline forecast for 2021?
Goldman’s rates strategists expect nominal 10-year US Treasury yields to rise to 1.5% by year-end 2021 with the majority of the increase coming from real yields rather than breakeven inflation. They expect yields to reach 1.85% by year-end 2022, while expecting the Fed to remain on hold until 2024 and for the Fed to start tapering asset purchases in 2022. Although they expect rates to rise, their 2021 forecast would still rank in the 3rd percentile relative to the realized level of rates during the past 40 years.
As such, “equities remain attractively valued relative to the level of bond yields” but not any other valuation metric where stocks are in the 96%-100%-ile. Indeed, equity valuations are stretched in absolute terms; an average of P/E, EV/EBITDA, EV/Sales, and P/B rank in the 96th percentile relative to the past 40 years. However, in an attempt to justify its 4,300 year end price target, Goldman says ignore all that because, you know, “metrics that account for the low level of bond yields appear more reasonable.” Well, of course they do when you are bullish.
Meanwhile, in response to investor concerns about a “bubble,” Goldman counters that the current ERP is 5 pp above the Tech Bubble, when the ERP approached zero: “We recently highlighted pockets of the equity market that are experiencing “bubble-like” tendencies, but which ultimately remain a small share of market cap. However, smaller growth stocks with extremely high valuations (EV/Sales greater than 20x) have historically struggled to grow into those multiples.”
Finally, while Goldman forecasts the S&P 500 will rise by 14% to 4300 in 2021 despite higher interest rates, the bank expects the “return will be more earnings-driven than valuation-driven”, which is good since PE multiples have never been higher. This is notable because the majority of the S&P 500 return in 2020 was driven by lower interest rates, demonstrating that a lower discount rate could more than offset the fundamental impact of the pandemic recession. Furthermore, Goldman expects rising rates will be driven by improving growth rather than monetary policy in 2021 (which is a fine expectation until we get a spike in inflation).
8. One Final Question: What can the “taper tantrum” of 2013 teach us about the market in 2021?
Goldman expects Fed tapering to begin in 2022, however many investors believe that a strong economic recovery will lead the Fed to begin tapering asset purchases earlier, disrupting the equity market akin to the 2013 “taper tanrum.” During the “taper tantrum,” the S&P 500 dropped by 6% initially, but ultimately resumed its upward – albeit volatile – path. During a May 22 Congressional appearance, Fed Chairman Bernanke indicated that the Fed could step down the pace of asset purchases if they saw continued economic improvement. Then, at the June 19th FOMC press conference, Bernanke stated that the FOMC anticipates that it would be appropriate to moderate the pace of asset purchases later that year. The 10-year US Treasury yield rose sharply, driven by real yields, and the S&P 500 dropped by 1.4%. As interest rates continued to rise towards 3%, the S&P 500 struggled to maintain new highs in 3Q 2013. Eventually, the bull market in equities marched on and the correlation between equity returns and bond yields resumed its positive relationship.
Looking beneath the market surface, the thematic rotations during the “taper tantrum” varied. Following Bernanke’s initial comments on May 22, the nominal 10-year US Treasury yield rose by 26 bp over the span of a month (1.9% to 2.2%). The thematic performance during this time was consistent with traditional relationships with rising rates. However, following the FOMC press conference, bond yields rose by 40 bp in a week and the macro backdrop was risk-off, consistent with the above discussion of speed earlier. Small-caps and cyclicals lagged despite their historically positive correlation with rising interest rates. From June 25 to September 5, as rates gradually rose, those high-beta strategies sharply outperformed. Interestingly, growth stocks and NDX continued to outperform despite the parallel shift higher in rates.
Mon, 02/08/2021 – 14:34