David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
Well, it finally happened.
After all the watching and waiting, the yield on the 10-year T-note has broken above 3 per cent and is now heading into overshoot terrain.
The problem for the equity market is that this is not about rates rising because the economy is doing so well. The regional Fed surveys, so far, are actually pointing to a 3-point pullback in both Institute for Supply Management ( ISM) surveys for April, as a prime example.
This last leg up in bond yields since mid-March has been driven by inflation expectations, not by real rates, and that is a problem for the stock market since the latter would at least symbolize rising real economic growth.
And the rise in inflationary expectations is purely cost-push in nature, and, as such, is beginning to crimp lofty profit margins. Only the most obtuse cannot see we are into a mild form of stagflation, and this is very rarely beneficial for financial assets writ large.
So we had Caterpillar shock the market with its blunt honesty Tuesday in its comment that Q1 was the “high water mark for the year” with respect to its earnings profile. Then Google ramped up its spending more than expected and is causing analysts to reassess the earnings and margin forecast as a result.
Something else to consider is what rising rates are doing to the rate-sensitive sectors.
If rising rates were truly commensurate with a buoyant economy, we wouldn’t be seeing the homebuilding stocks down 20 per cent from the recent highs, the automakers down 16 per cent, home improvement off 18 per cent, building materials down 18 per cent, and real estate sliding more than 10 per cent.
After all, we did recently hear from both KB Homes and Pulte that “pressure” on “commodities” (same words by both companies) were squeezing their margins (lack of workers and tariff-induced increases in lumber prices).
Of course, the President’s saber-rattling over Iran may have played some role, at the margin, in further compressing the P/E multiple. Investors are also seeing right in front of their eyes what the payback is for all the tax cuts ($1.5-trillion) and public spending largesse ($300-billion), which is a massive government bond crop at a time of 4-per-cent unemployment (call it 2 per cent if you actually are employable).
This is competing for funds from other asset classes, and, all of a sudden, the 10-year T-note gives an income-hungry boomer a 100 basis point premium over the S&P 500 dividend yield.
There is a deluge of debt issuance from Uncle Sam this week, in the form of $96-billion of two-, five- and seven-year notes (the $32-billion sale of two-year T-notes generated a 2.49% yield, which is the highest in a decade). Trillion-dollar-plus fiscal deficits at a time when the Fed has already shrunk its balance sheet by a total of $100-billion, and more is coming.
And with the Administration attempting to shrink the trade deficit, which ipso facto means reducing the capital account surplus (half of last year’s budget deficit was financed by foreign investors), this is one reason, over and beyond inflation, as to why bond yields are moving irregularly higher. The laws of supply and demand may well be the simplest explanation for this rates backup.
So yes, for equity investors, a big part of the story is interest rates.
For people to tell you that it is okay because it reflects a hot economy (i) that isn’t even true since there is scant evidence yet of a Q2 GDP bounce-back and (ii) there is nothing more powerful in influencing asset values than interest rates, which is why Albert Einstein called them the eighth wonder of the world. They have the most influence in determining the present value of those future cash flows that are critical to any valuation work undertaken for the equity market.
Try deploying the capital asset pricing model or a dividend discount model, where appropriate, without understanding the power of interest rates. It is not about the level (as I hear all the time “oh, don’t be worried till we get to 4 per cent on the 10-year note”) — it is always about change.
The fact that the marginal investor has bought into the stock promoter rhetoric is concerning. The Investors Intelligence poll showed that last week, the bull share rose from 44 per cent to 48 per cent, while the bear camp remained just below 20 per cent. Imagine that, despite all we have seen in this meat grinder of a market, there are still more than two bulls for every bear out there. Amazing.
Rest assured that market bottoms don’t typically occur until the bulls and bears change their representation in this survey. Sentiment is far from washed out, and until it is, all bets are off on calling the trough — cheaper valuations notwithstanding.
It is vital to emphasize that it is not about the level. It is about the change (emphasis needed), because markets always and everywhere respond to the change that occurs at the margin.
It was NOT the 5.3-per-cent LEVEL on the 10-year T-note yield by the summer of 2007 that ultimately brought the stock market to its knees, it was the 200 basis points run-up from the 2003 post-crisis yield lows — the CHANGE — that did the trick. It was not the 6¾-per-cent yield on the 10-year T-note that undid the dotcom bubble back in 2000; it was the 200 basis point surge from the post-crisis (Asia and LTCM) yield lows in late 1998. It was not the 9-per-cent yield on the 10-year T-note that caused the bear market and recession in 1990-91, but the 200 basis point move off the 1987 trough that caused it.
Too many people focus squarely on the yield curve, but more often than not, when the 10-year yield rises 200 basis points or more from the cycle lows (and those lows are always seen as egregious lows at the time they happen), it is just the change in rates that upsets the apple cart. At this point, I suppose we are just too close for comfort with the 10-year note yield up more 170 basis points from those post-Brexit lows.
Look, I could go back cycle after cycle to prove the point, but, for the sake of time, I’ll leave it here. To reiterate, from the summertime 2016 lows, we are getting perilously close to a classic 200 basis points move up in the 10-year rate. This will (and is) pack a powerful punch for anything that is valued on the direction (again, not the level … snap out of it!) of interest rates. And if the latest Goldman Sachs forecast of a 3.25-per-cent yield in the 10-year proves prescient, we will get there before too long, but Mr. Market may be saying “I ain’t gonna wait around.”
In my role, I obviously get asked all the time to “call the market.
Well, this is a time for the strategist to play student as opposed to teacher and let the markets dictate what’s going to happen.
For example, whenever the VIX averages 50 per cent or more from where it was the prior year, just know that history tells us with 100-per-cent% accuracy that this is commensurate with a weak, not a strong, stock market. This is a regime change. And look at the number of sessions this year we have seen 3-per-cent-plus intra-day swings in the Dow (as we experienced yesterday) — 9 so far, 6 down and 3 up.
We haven’t seen anything quite like this all cycle long, and the last time was (gulp), in 2001, before that it was 1998, then 1990 and then 1982.
Sorry, but there is no “get out of jail free” card when the Fed is raising rates and shrinking its balance sheet. The simple message really is what worked from 2009 to 2016, which was don’t fight the Fed! Except now the movie reel is going in reverse.
David Rosenberg