Follow-ups and New Thoughts:
1) Emerging Markets are still exciting for the long run, but surging interest rates are not helpful for this asset class. Higher yields in the U.S. hurt EM in two ways – they raise the relative attractiveness of U.S. bonds and they raise the cost of financing U.S. dollar denominated debt. So if you are Malaysia, for example, to the extent that you have issued a bond in dollars, you now have to set aside more ringgits for conversion to dollars to pay interest and eventually principal to bondholders, thus your money supply constricts and your economy suffers. The U.S. has a lot of structural problems, but the dollar remains where money flows in a crisis.
2) The 10-year yield going from 92 basis points on December 31 to 109 basis points at the end of January was not upsetting to the market, nor should it have been. On the other hand, the spike to over 150 basis points by February 25th was not expected and not welcome. Moves that sharp – 109bp to 150bp is a 37% increase – are multiple sigma events, so they are outside of the risk tolerance bands of most trading firms. In other words, they may not have been properly hedged. Markets may trade with unusual volatility if one or more funds finds itself with a liquidity problem.
As it stands now, long term bonds are oversold so a little consolidation should be expected. The 10-year is in a range from 1.40% to 1.50%. A sustained move back below 1.40% is bullish for growth stocks and emerging markets. Conversely, a retest and break of the recent 1.53% is bearish for all but commodity and financial services related value stocks if it occurs in the next week or two. If, however, interest rates move up through recent levels on a gradual basis over several months tied to a strengthening global economy, I believe it will not be bearish for 90%+ of the stock market. Markets tend to be able to digest gentle interest rate increases but not rate spikes.
That said, I am more worried about how high bond yields can go in this recover phase, and for how long, than I was a month ago.
3) Blackrock put out an excellent piece recently called “The Queen’s Gambit Declined”. The piece makes reference to the actual Chess strategy that the recent Netflix series was taken from. The strategy known as the Queen’s Gambit involves sacrificing a pawn to gain initiative and control of the center of the chessboard. Blackrock’s analogy involves underweighting bonds for cash. You forego the yield of bonds (not that much anyway) but you retain the optionality of cash – in other words the ability to deploy it easily wherever opportunities might arise. We are very willing at this point to hold lower than usual bond positions and higher than normal cash in portfolios.
4) In the technology space, the biggest winners over the past 11 months tended to be the biggest losers last week. Growth stocks in general have struggled over the last three months RELATIVE to value stocks because the former are more interest rate sensitive. Growth seems to do well only on those days where interest rates fall. This raises an interesting portfolio management conundrum. Bonds are often held as “ballast”, or that which helps a portfolio to not decline as much if equities have a rough time. Yet over the past several months growth stocks have had a high correlation with bond prices. I would argue that the ballast argument has become almost completely unsupportable for growth stocks. Value stocks, which are more economically sensitive, still often gain on modestly weak bond days. I believe this is (another) good argument for lightening up on interest sensitivity in bond portfolios, either by shortening bond duration or marginally reducing exposure to bonds in favor of other asset classes. Today, what protects your portfolio from momentum stock losses is not Treasury bonds but deep value stocks.
5) The recent SPAC (special purpose acquisition company) boom is interesting. Not for the obvious reason that many of these are blank check companies[i] with high fees and no operations to analyze, but because they are helping to reverse a two-decade trend of share shrinkage which many believe has helped fuel the bull market. In other words, mergers and buybacks reduced both the number of companies and number of shares outstanding, which pushed stocks upward from a supply-and-demand standpoint (those monthly dollar cost averaging payments have to go somewhere). Now, however, buybacks have slowed post-Covid while new entrants to the market (SPAC or traditional IPOs) have been very strong over the past year.
All of this is in a way can be read as: God help us all when the Federal Reserve stops (or is forced to stop) pumping liquidity into the economy. I don’t expect this to happen soon and in fact 2021 could very easily see a melt-up as overly accommodative monetary policy and a strong post-Covid economic recovery converge. I’m just saying that valuations are in the 100% percentile historically NOW, so that if we lose our minds 1999 style and the Fed is forced by inflation to try to deflate the liquidity balloon with the S&P at 5000 or more (as they had to in early 2000 with the NASDAQ over 5000) a similar debacle could ensue.
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[i] Meaning that the offering merely lists who is going to operate the entity and what they hope to do with your money, as opposed to those offerings that fund a specific company and give you financial information on that company.