As has always been the case, investors keep an eye on two principle themes when modeling investment strategy; economic data and valuations. In the case of the former, I would argue that monetary policy takes top billing. I and many other market strategists have written voluminously on the subject over the years. As a result of my focus on this theme, I was naturally struck by last week’s dramatic move higher in interest rates. In as long as I have been an active participant in the markets, I can recall few times that the US 10-year yield moved as dramatically as it did this past week.
From Monday’s open to Friday’s close the US 10-year yield rose 16.50%. On Monday the yield was 1.8190%, Friday it closed yielding 2.117%. Not only that, on an intra-week basis, the swing was even more pronounced. Further, the lion’s share of that move came after Tuesday’s Presidential election.
In a word, it was a dramatic week. As dramatic as it was, it also has acted to inform investors that the odds of the Federal Reserve finally moving on a follow through rate hike after twelve months is being baked in by traders.
Much of the move was directly tied to the elections of course, but not all of it. The steady drum beat of employment gains coupled, the steady decline in the official unemployment rate coupled with recent economic data that provided evidence of modest, but important, wage growth has also played a part in the shift higher in rates. As quoted on FoxBusiness last week, “do think we will see a very substantial and meaningful rebound in equity prices over the long term because his approach to the economy is radically different than what we’ve seen for 16 years and what the markets are going to find is healthier for U.S. companies.”
The significance of last week’s move higher in the US 10-year yield was underscored by the sharpest weekly rally for US equities in nearly five years. We are at an inflection point, and investors would be well served to pay attention.
Not all equity rallies are equal. In recent years, equity market rallies have largely been fueled by monetary policy accommodation, intermittently interrupted by uneven economic data, volatile energy prices and geo-political risk variables. As a result, caution has bled into investor outlook due largely to inflated equity valuations. This has been the case in particular over the past five quarters were we have witnessed a continuous decline in revenue growth on the part of the S&P 500 as a whole, while capital has continued to be allocated to the space. This week’s rally came in the face of rising rates, despite no movement by the Fed in its most recent FOMC Announcement.
In the short term I indicated on CNNMoney, “We have seen such a powerful and broad move higher in U.S. equities over the last two-plus days that it is only normal that we would see a little bit of pause, particularly in the financials,” and “conventional wisdom would see see the potential for a significant pullback in the emerging space because of the narrative around trade and what free trade really means.”
Institutional investors are betting on rising rates and rising equity prices.
That is unfamiliar territory for anyone that has been involved with markets over the past eight years. It also means the institutional investors are expecting the US economic expansion to accelerate in coming quarters. For a quarter or two, we may see a degree of inflation in valuations, but if the smart money is correct, our recent quarterly string of revenue/earnings contractions may be coming to an end, in which case, improved earnings will ultimately underpin revenue growth, earnings growth and higher equity prices.