At the beginning of the year, we witnessed a sharp inverse relationship between stock prices and bond yields. What should we do about it?
By the end of the first quarter of 2021, the yield of the reference Government of Canada 10-year bond rose to 1.55%, up from 0.67% at the end of 2020, a hike of 88 basis points, reports Konstantin Boehmer, senior vice-president and head of global macro and quantitative analytics at Mackenzie Investments. Similar increases happened across developed countries, causing bond indices to fall sharply. In response, he notes, the Bank of America Merrill Lynch Global Broad Market Index fell 4.3%. In Canada, the FTSE Canada Universe Bond index fell 5%.
Cause is Key
Of course, a rise in bond yields does not happen in a vacuum, reminds Drummond Brodeur, global strategist at CI Global Asset Management. There is an anticipation of a strong recovery, vaccination is progressing, the U.S. government is considering US$ 2.25 trillion in spending, and there’s a tax proposal. “All that plays into the broad bond market,” he says.
But it is also playing into the stock market. Much of the rise in stocks was predicated on the idea that bond yields were comparatively low. Now, with yields rising, that idea is brought into question. “When yields are low, valuations can be higher, comments Philip Petursson, chief investment strategist and head of capital markets research at Manulife Investment Management. But as yields move up, there has to be an offset on stock valuations, though it’s not a one-to-one relation. We were expecting a rise in yields, but the move in the first quarter was a lot faster than expected. Still, this is very typical coming out of a recession – only faster.”
Going forward, Brodeur and Petursson see yields inching their way up to 2% by the end of 2021. This has already affected stocks, and will continue to, prompting the question: which stocks will win, which will lose? “Some sectors are more sensitive to yields rising,” Petursson says, “Some will probably underperform the market, like technology stocks, consumer staples, utilities and telecom, others will gain, like cyclicals, energy, materials, industrials and financials.”
The Inflation Conundrum
But nothing in investing is as straightforward as picking the right sector in response to yields, warns Anil Passi, managing director, global corporates at DBRS Morningstar. Inflation’s now a key variable in investors’ decisions. “There’s much debate about whether inflation will be transitory, as the Federal Reserve believes, or if it will be sustained. Some think that yields will rise because of inflation, others, because of economic growth, others, because of a combination of both.”
Passi is not a forecaster, so he refuses to take sides in this debate. However, depending on how inflation behaves, he gives us an idea of how key sectors will evolve. “If you believe that inflation will be more than transitory, you will favour materials, energy, industrials and staple consumer products where producers can pass on price hikes to consumers.” Passi characterizes these sectors as being of “short duration”.
On the other hand, ‘long duration’ sectors will suffer from higher yields, such as services, consumer discretionary products and, most notably technology says Passi. “Companies in this sector do well when yields are falling, not so much when they are rising because investors discount future earnings at a lower rate,” Passi explains, “On money that will be paid in 20 years, I don’t mind that the company is reinvesting and holding back dividends. But rising yields cause a dollar earned in 20 years to be more depreciated.” He compares this to an energy company, an example of a “short duration” play: “You don’t know how it will be in 20 years, but you know their earnings could be strong in the next year or so, and the price of their commodity is going up.”
The other side of the argument is if the rise in yields hinges more on economic growth than on inflation. “In that case, adds Passi, you’ll want to be more balanced in your allocation.” He illustrates his argument with the banking sector. Rising yields that hinge on economic growth more than on inflation are very favourable to banks, especially in the context of a steepening yield curve as we presently witness. “A bank borrows short term at a low rate and lends long term at a higher rate.” The larger that spread, the greater the profit, and with economic growth, lending activity increases. On the other hand, a rise in yields linked to inflation can turn around to bite banks because, in an inflation context, defaults increase, pressing on earnings.
Great Canadian Short Duration
While long-term investors eagerly await the outcome of the inflation vs. growth debate, the advantage appears to have turned toward “short duration” companies. For example, in Canada, since the end of November 2020, Suncor’s (SU) and Canfor’s (CFP) stocks have soared, with the former moving from $11,29 to $20,68, and the latter from $20.83 to $32.14. Royal Bank (RY) rose from $70 to $94.50.
On the other hand, in that same period, technology stars like Shopify (SHOP) and Facebook (FB) have slowed down considerably, the first gaining only 12%, and the other, 16%. Of course, there are always exceptions, with Tesla’s stock (TSLA) having vaulted by 82%.
The move to “short duration” greatly favours the Canadian stock market, point out Petursson and Passi. “This is a year where Canada could do better than the U.S., Petursson notes, thanks to three sectors: energy, materials and financials.”
