By Thomas A. Martin, CFA, Senior Portfolio Manager – GLOBALT Investments.
There’s the so-called “Big Rotation” out of bonds and into stocks. These days, it all starts with the virus, vaccine success and re-opening, the increasingly large snap-back rebound in GDP, and trying to handicap inflation and what the Central banks will do about it. Massive stimulus, pent-up demand and savings, supply chain kinks, low labor force participation—it all seems pretty reasonable. Rates are on the rise because market participants think rates are on the rise.
Actually though, talk of the big rotation started well before COVID, and it all started with interest rates being lower than almost anybody could imagine at the time. That was when the 10-year U.S. treasury yield broached the 1.5% level in 2012, nearly ten years ago. 2013 was the first “taper tantrum,” and folks were certain that we’d kissed the bottom on rates for the 30-year cycle. An imminent rise in rates and a rotation into stocks has been expected any day now ever since.
That interest rates could be negative was as incomprehensible back then as a fish riding a bicycle. Now your Cat in the Hat goldfish can order a Peloton on-line, have it shipped to the house, and do a virtual workout right in the bowl. Who needs legs?
Just last year when the ten-year yield cliff-dived down into the 50-basis point tub of water, there was a not-small cohort in the audience that thought we’d go negative in the U.S. It’s worth keeping in mind that the underpinnings supporting that line of reasoning were very high levels of debt, unfavorable demographics, and low productivity driving very slow growth that could only be sustained (for how long?) by ultra-low rates. That, by the way, has not changed—there’s even more debt now and we are not getting any younger, or more productive for that matter. Meanwhile, the idea of some level of “permanent income” gains increasing traction. There are shorter cycles and longer cycles. It pays to know the one in which you are pedaling.
That said, the flows lately have been out of bonds and into equities. At the same time, lots of U.S. Treasury debt (lots and lots) will need to be sold to finance the stimulus with heightened focus on the auctions of these larger nominal amounts. What is the composition of the types of buyers, and what are they doing with the stuff once they have bought it? Once it gets sold, it has to be serviced with this thing called interest payments. The higher the interest rate and the more principal to which the rate is applied, the larger the burden on the payer. That would be you and me. There is an incentive to keep that burden from blowing up.
There’s the style rotation from growth to value and large to small. The prior rotation was pretty much one sided for the past several years favoring growth over value and large over small. The gaps between both of which got very big. The market took several swings at reversing that rotation last year, largely without success. Until the last three months of the year, when the rotation back to value and small cap stocks started to get its base, driven mainly by the amazing vaccine news, the crowded one-way positioning, and the yawning performance differential. That has continued thus far in 2021 and the new rotation is showing signs of sticking.
The factors driving the rotation into equities from bonds (as pointed out above in the Great Rotation section), are also driving a rotation out of names benefitting from the fallout from COVID which remain higher, and into COVID recovery names, which had been pummeled, but have recovered to near and even above pre-COVID levels.
The result is that nothing is “cheap” anymore, and the relative attractiveness of one versus the other is not at all clear. This is a set up for more emotional factors to drive movements in these cohorts; another recipe for the volatile swings from one to the other that we have seen the last couple of weeks.
There’s the sentiment rotation from greed to fear. What fear you might ask? There’s very little to be found judging by the two rotations above. Equity markets remain at all time highs, and fixed income is being sold. The VIX (a measure of the CBOE Volatility Index) tells a bit of a different story though. The 20 level is an informal line between “less volatile” and “more volatile.” It stayed mostly above this level from 2007 to 2012, the same period during which the S&P 500 recovered from the Great Financial Crisis. The VIX stayed mostly below this level from 2012 until COVID hit in 2020 but has since moved back above 20. The current level in the low 20s may not be indicating out-and-out fear of the panicky sort, but it is reflecting elevated uncertainty and a high level of nervousness among investors. The mindset is more akin to “can’t participate if you’re not in, can’t protect if you’re not out, so I’m in now, but I want to be out before you.” That is a set up for spikes in volatility.
Our Gyroscope remains the weight of the evidence. Being whip-sawed in an unstable environment is no way to invest money needed to meet real long-term goals. Our investment process is designed to maintain and evolve positions that express exposures that the evidence from multiple sources suggests is best suited for the intermediate term future. We execute this process through a combination of both tactical and secular holdings. Our current positioning remains tilted towards the conservative side.
Source: FactSet, Cornerstone Macro. Data and Analytics provided by FactSet.
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