by Shawn Narancich, CFA
Executive Vice President
Prove It!
Federal Reserve Chairman Jay Powell briefed lawmakers this week on the state of monetary policy, assuring members of Congress that the central bank has no intention of raising interest rates anytime soon. Messaging during his testimony sought to solidify the same message his FOMC colleagues have proclaimed in recent weeks, namely that the Fed will not pre-emptively raise interest rates this go-around until three conditions have been met: 1) full employment 2) consistent achievement of its 2 percent inflation goal and 3) inflation expectations meeting or exceeding this target.
Equity investors at first took the glass half-full interpretation of Powell’s assurance for ongoing monetary stimulus, with its attendant tailwinds supporting economic growth and earnings recovery. Ultimately, the bond market took centerstage, creating the catalyst for some profit-taking in stocks amid a reappraisal of rising interest rates on the longer end of the yield curve. As the chart below shows, yields on the benchmark 10-year U.S. Treasury bond have now eclipsed pre-pandemic levels, nudging above 1.5 percent this week.
Revenge of the Bond Vigilantes?
This week’s 1.5 percent year-over-year reading on the Core Personal Consumption Deflator Index, the Fed’s preferred benchmark of inflation, affirms work remains to be done. More than 10 million people are still out of work compared to pre-pandemic levels at the beginning of last year, and with unit labor costs remaining subdued amid above-average levels of unemployment, we do not expect either bond yields or the inflation rate they reflect, to surge from here. Labor costs are key to the inflation outlook because, on average, they account for over half of product and service costs.
All About Style
Stock prices are, nevertheless, sensitive to the level of interest rates because they are a key determinant of the cost of equity that investors use to discount future earnings — the higher the rate, the less investors are willing to pay for earnings farther into the future. With benchmark Treasury yields up over half a percentage point year-to-dated to 1.4 percent, longer duration growth areas of the market like software and internet stocks are underperforming. The chart below (which shows the Russell 1000 Value Index relative to the Russell 1000 Growth Index) highlights how more economically-sensitive value stocks weighted to the banks, energy and non-Amazon retailers have assumed market leadership.
Value vs. Growth
As measured by the Russell 1000 Value and Growth indexes, value stocks have outperformed growth stocks by approximately 5.5 percentage points so far this year. This outperformance began in earnest last fall with news of the successful vaccine results from Pfizer and its partner BioNTech and has become more pronounced recently. Under a new administration, additional stimulus is being shepherded through Congress and, within a few days, we expect Johnson & Johnson’s COVID-19 vaccine to receive approval; both are catalysts for faster economic growth ahead.
The history of markets tells us, somewhat paradoxically, that when economic and earnings growth picks up, value stocks outperform growth stocks. To benefit from potential acceleration in economic recovery, we have transitioned our equity exposure for client portfolios away from “growthier” technology and communication services stocks into more cyclical, value-based sectors like the financials, industrials and (most recently) energy, that likely offer better earnings growth prospects and more resilience to higher interest rates. More broadly, we continue to overweight large cap U.S. equities on the belief that robust earnings growth will more-than-offset the modestly-higher levels of interest rates we foresee.
Our Takeaways from the Week
Stocks retreated as benchmark bond yields broke through the 1.5 percent level
Value stocks continue to outperform as economic recovery stands to accelerate