When we commented yesterday on the question du jour, namely at what yield on the 10Y Treasury will stocks get hammered, especially with both the dollar and oil surging, we referenced a recent piece by Goldman’s Ian Wright according to which the answer whether equities will perform well from here “ultimately rests more on growth than rates” with Goldman going on to show that “historical performance supports this view, with returns directly related to growth changes but generally unrelated to yield changes after growth is controlled for.”
Here Goldman cautioned that while until now higher rates have not managed to pressure stocks materially, “at some point higher rates turn from signalling an improvement in growth to signalling tighter financial conditions, which weighs on growth.” The good news is that according to the bank, “growth will remain strong enough over the next 12 months so that higher rates alone will not drive a sharp turn in the cycle, although they may lessen returns.”
And while it is hardly cotroversial that when one cuts through the noise, all that matters is growth, a far less optimistic outlook on this interplay of equities and bonds comes from SocGen’s Andrew Lapthorne, whose bearishness is prompted by the following observation:
“The weak US dollar and what were still relatively depressed bond yields were two supportive factors driving equity markets last year, particularly against consensus expectations for a far stronger US dollar than what actually materialised. These positives are now in reverse and markets are responding accordingly.”
One can already see a manifestation of this slowdown in emerging markets – which have been struggling more than during the 2008 financial crisis – driven by the sharp spike in the USD and rise, with the MSCI Latam sliding 5.9% last week, while bond proxy sectors are proving to be anything but defensive, as Lapthorne notes.
Furthermore, the tightening in financial conditions and the sharp spike in yields means that inflation and rate-sensitive staples Tobacco, Telecoms, Household Goods and Beverages were all among the biggest losers globally last month. As a result, the SocGen strategist writes that “investors are now torn between wanting to avoid expensive valuations in the higher quality stock universe and the balance sheet risk typically associated with the cheaper value universe. Little wonder global sector leadership is becoming increasingly narrow in 2018.”
But it could get even narrower if, as both Goldman and SocGen predict, it is only a matter of time before higher rates lead to a wholesale equity selloff. Indeed, as Lapthorne concludes, “the correlation between bonds and equities remains a significant debate, or to put it more directly investors are increasingly concerned about losing money on both assets at the same time.”
And the worst news:
Despite throwing everything and the kitchen sink to spur asset markets, some long term asset market problems have not gone away. For example the running real yield on a balanced portfolio, pre any management fees or trading costs, sits at a miserly 50bp, near an all time low, and despite asset markets having benefitted from QE, 5 & 10 year realised returns continue to trend lower.
And while a coordinated selloff, one which could potentially wipe out the risk-parity industry, is certainly long overdue, it won’t come tomorrow: as the following chart from Goldman shows, while cross-asset correlations recently soared to the highest level over a year, the recent fade in the VIX meant that x-asset vol has once again faded not too far off all time lows.
Meanwhile, stocks remain resilient for at least one more day, aided by a drop in both yields and the DXY. That will change if the Fed is indeed intent on hiking 3 more times in 2018 and another 4 in the coming year…