Blog Posts — March 12, 2021

Anxious about rising yields and inflation? Here’s why (perhaps) you should be…

by Christoph Schon, CFA, CIPM

Rising interest rates are customarily accompanied by gains in stock prices and increasing consumer prices, which are usually seen as signs of a healthy, growing economy. There may come a point, however, when (expected) inflation becomes so high that the central bank may feel compelled to tighten monetary conditions. If done too abruptly and aggressively, that can have an adverse effect on stock and bond prices alike. In this article, we demonstrate how a stress test can be used to estimate the impact of an additional 50-basis point surge in US Treasury yields on individual sectors within the STOXX® USA 900 index.

In our recent blog post on When ‘good’ inflation becomes ‘bad’ inflation – 2018 reloaded?, we highlighted the parallels between the current environment and early 2018. Back then as now, a rise of breakeven inflation above the Federal Reserve’s 2% target triggered a sudden drop in share prices, accompanied by a sharp surge in long Treasury yields. What followed was a prolonged lateral movement of the US stock market, as sovereign rates continued to rise. In the end, it took the STOXX® USA 900 more than six months to surpass its previous peak.

February 2018 was not the only environment, though, in which a stock-market correction was accompanied by a surge in Treasury yields. The table below shows a sample of historical periods in which a rise in expected inflation was followed by a simultaneous sell-off in both asset classes. The losses for the STOXX® USA 900 ranged from -2% to -10%, while the 10-year benchmark rate climbed between 44 and 63 basis points. The fourth column shows the 10-year US breakeven inflation (BEI) rate at the start of each period[1]. The last column indicates how many days it took share prices to revisit the previous peak.

Historical US market movements

Source: Qontigo

From the all-time high on February 12, 2021, to the latest low on March 5, US share prices declined 3.5%, while the 10-year Treasury benchmark rose 36 basis points to over 1.5%. The equity sell-off was spearheaded by so-called “growth” stocks—companies that are expected to derive most of their earnings and cashflows in the distant future, which then get discounted back to the present value at higher rates. These firms can be found in the Consumer Discretionary (which includes online retailers) and Information Technology sectors, which did indeed experience the biggest losses. “Value” sectors, such as Financials and Energy, on the other hand, outperformed the overall market and, in the latter case, even saw their share prices increase.

The question now is whether these trends are likely to persist, if long-term sovereign yields were to rise even further–which seems like a distinct possibility, given the persistently high inflation expectations and the anticipated borrowing required to finance the announced $1.9tn US stimulus package. To estimate the impact of a further rise in interest rates on the American stock market, we performed a scenario analysis in Axioma Risk™. The table below shows projected sector performances for a further upward shock of 50 basis points in the 10-year US Treasury yield. It is worth noting that they are not actual past returns, but simulated price changes using covariances and betas estimated from daily stock and interest-rate returns during the periods given in the table above, which correspond to the years displayed in the header.

Simulated equity returns for a 50-basis point upward shift in 10-year US Treasury yields

Source: Axioma Risk™

The analysis predicts a further decline in the overall stock market of nearly 7%, with losses across almost all industries. The stronger decline in the most recent scenario reflects the additional uncertainty from the ongoing coronavirus pandemic. The notable exception is the Energy sector, which exhibits a gain of around 3%, thanks mostly to the recent surge in oil prices. Utilities and Financials also seem to fare much better than the overall market, recouping some of the excess losses they suffered during most of 2020. Those two were also among the best-performing sectors in the 2018 scenario.

On the other end of the spectrum is Information Technology, which shows an almost 12% drop in the most recent environment and a below-market returns in both 2005 and 2018. Consumer Discretionary, on the other hand, only exhibits a large loss under current conditions, reversing a small part of its stellar performance in 2020, which had been driven by the surge in online shopping during the various lockdown periods.

Admittedly, the projected losses still appear relatively small compared with the rout 12 months ago and the spectacular gains in the subsequent recovery. However, persistently strong (expected) inflation is likely to erode future profits, which are then discounted at increasing interest rates. At the same time, higher yields on bonds will eventually turn them into a more attractive alternative to equities, which is bound to add even more downward pressure on share prices. So, compared with the relatively modest downturns we have illustrated, the impact could be larger in magnitude, last longer, or both.

1 It is worth noting that the Federal Reserve only started to target inflation officially in 2012.