September 1, 2022
It’s Still About Rates & Inflation
Tim Urbanowicz, CFA
Head of Research & Investment Strategy
Innovator Capital Management
Late last year, we outlined why traditional risk management strategies that have worked so well in the prior regime, characterized by low rates, low inflation, and consistent growth, would be less effective moving forward. Our view was rooted on the premise that the risk reward tradeoff for core bonds was extremely poor. Structurally, higher inflation was likely to pressure rates higher, low starting yields would limit upside potential, and diversification benefits were unlikely given the common risks facing both equities and bonds. While a lot has taken place in the first eight months of the year, we still see a similar backdrop for investors. This month, we unpack this view and why we believe investors are better off exploring ways to tie their “lower risk” dollars to the equity market over the bond market.
Different Markets, Same Risks
In early February, the correlation between the S&P 500 and the Bloomberg US Aggregate Bond Index rose to 0.5 and has remained above that level ever since. This represents a multi-decade high and, in our view, is unlikely to change anytime soon.
Source: Bloomberg LP as of 7/31/2022, S&P500 Index, Bloomberg US Aggregate Bond Index. Past performance is not indicative of future results. One cannot invest directly in an index.
Inflation, an aggressive Fed and higher interest rates have plagued the equity market and bond market all year long, and remain the key issues going forward. As such, stock/bond correlation is likely to remain elevated as well, as both markets react to changes in inflation expectations, rates, and Fed action. As shown in the table below, with the exception of March, the S&P 500 Index and the Bloomberg US Aggregate Bond Index have directionally moved in tandem with one another, and opposite the US 10-year yield each month.
Source: Bloomberg LP as of 7/31/2022, Core Bonds represented by the Bloomberg US Aggregate Bond Index
US Equity Market Composition Has Changed and is Now More Sensitive to Rate Moves
The equity market looks drastically different today than it has at any point over the last 15 years. The continued rise of Technology stocks has left the S&P 500 with a sizeable tilt towards growth stocks, and away from value.
Source: Bloomberg LP as of 8/24/2022.
As many growth stocks tend to have cash flows further out into the future, this composition shift has increased the duration of the equity market, making it more sensitive to changes in interest rates. This dynamic is clearly illustrated by the correlation of interest rates and the valuation of the US equity market. As shown in the chart below, the forward PE of the S&P 500 has more closely tracked changes in the 10Y treasury yield over the past five years, relative to the ten years prior. The drop and subsequent rebound in the S&P 500 have been almost entirely driven by the rate driven adjustment to the valuation.
Source: Bloomberg LP, S&P500 Index, Forward Price to Earnings Ratio, Generic US 10 Year Treasury Index
Bond Upside Still Limited, Equities Over Bonds Should Risks Subside
Given the heightened sensitivity of equities to changes in interest rates, should the shared risks discussed prior moderate, we believe equities are likely to experience a more meaningful rebound in relation to bonds. This was clearly illustrated with the drop-in rates and equity market rally thus far in Q3.
Additionally, even with the increase, current bond yields still likely point to limited upside moving forward. The chart below highlights the historical starting yield and subsequent ten-year annualized return of the Bloomberg US Aggregate Bond Index, each calendar year since 1980. Over this timeframe, starting yield explained over 95% of total returns, with a standard deviation of just 0.69%. With a current yield of approximately 3.8%, generating a positive real return could be challenging.
Source: Bloomberg LP, Bloomberg US Aggregate Bond Index, R2 indicates how much variation of a dependent variable is explained by the independent variable.
Our Stance: Hedged/Buffered Equities Over Bonds
We continue to favor cautiously increasing equity exposure in a portfolio and believe investors may be better off tying their “lower risk” dollars to the equity market as opposed to the bond market. Hedged equity strategies, such as Buffer ETFs can be used to manage risk, and offer a potentially more attractive risk/reward profile.
Bond/Equity Correlation refers to how the equity market moves in relation to the bond market.
Bloomberg US Aggregate Bond Index is a proxy for the total US investment grade bond market.
10 Year Yield is the generic yield on a US generic 10-year government bond.
Forward PE is the current price of the security divided by the consensus estimated earnings per share.
Growth stocks are share in a company that is anticipated to grow at a rate significantly above the average growth for the market.
Value stocks refer to shares of a company that appears to trade at a lower price relative to its fundamentals, such as dividends, earnings, or sales, making it appealing to value investors.
Standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.
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