Don’t Be Freaked Out By Last Week’s Stock Market Selloff

Don’t Be Freaked Out By Last Week’s Stock Market Selloff
Carl Hazeley

almost 3 years ago2 mins

Mentioned in story

What’s going on here?

Long-term US government bonds haven’t had such a bad start to a year since 2009.

Bond performance

When bond prices fall, their yields rise. And investors have been squarely focused on 10-year US government bonds lately: their yields rose from 1% to 1.5% last month, sparking a sudden selloff in stock markets as well as a slew of questions from Finimizers. I thought I’d have a go at answering four of the most important ones.

1️⃣ Are rising bond yields a threat to stock market valuations?

💡 In short, no. Over the last three years, stock market returns have been strongest when real (i.e. inflation-adjusted) yields were falling and “breakeven inflation” (the difference between the unadjusted yield of a bond and the real yield on its inflation-linked equivalent) was rising. And while both breakeven inflation and real rates have been rising in recent weeks, US stock prices also tend to do well in that environment.

The second column (green diamond) shows the US S&P 500 rising 70% of the time in such a scenario
The second column (green diamond) shows the US S&P 500 rising 70% of the time in such a scenario

2️⃣ So why did stocks fall?

💡 Because yields rose too far too fast. In months where US 10-year government bond yields rise by more than two standard deviations, the country’s S&P 500 stock index has historically averaged a 5% drop. Put another way, if 10-year yields had risen 0.3 percentage points last month, you might have reasonably expected stocks to fall 5%. Yields in fact rose 0.5 percentage points (from 1 to 1.5%) in February...

Stock market real yield relationship

3️⃣ When will rising rates become a problem for stock markets?

💡 When US 10-year government bond yields exceed 3.5%. According to strategists at investment bank Goldman Sachs, the complex relationship between bond yields and the “equity risk premium” – the additional baseline return an investor demands for buying riskier stocks over safer bonds – suggests that as 10-year yields approach 4%, stocks will have to offer more earnings growth in order to remain as attractive.

Rates impact on markets

4️⃣ Which industries and investment styles are the biggest beneficiaries of rising yields?

💡 Cyclicals and value stocks. Rising rates typically drive an investor rotation away from defensive-sector bets and fast-growing companies and towards economically sensitive “cyclical” sectors and cheap-looking value stocks. Looking ahead, investors will have to balance the appeal of backing firms with high long-term growth potential against the risk that rates rise further and stock prices continue to outperform elsewhere.

Bank stocks typically outperform the market the most (their “beta” is highest) when bond yields rise
Bank stocks typically outperform the market the most (their “beta” is highest) when bond yields rise

To recap, then: don’t panic, keep an eye on the direction (and pace) of future US 10-year government bond yield changes, and perhaps consider tweaking your stock portfolio more towards value and cyclicals.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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