During the depths of the crisis, investors had been willing to pay anything for growth, valuations be damned. But the parabolic performance of growth stocks over value could not be sustained forever. This is demonstrated in the chart above by prior such occasions where the growth-to-value ratio has breached the 3 standard deviation Bollinger Band, which we use to denote a move of extreme proportions. Prior occasions have resulted in a clear reversion to the mean, in this case the 4-year moving average, in grey.

Whilst today’s world is not directly comparable to the dot-com bubble era – many tech stocks today are viable productive businesses – the narrative is the same and history has provided us a roadmap for how this might play out. As investors, our job is to adapt to this evolving theme characterised by a re-opening economy and the flow of money from growth to value and from Covid-19 winners to losers.

Over the last few months we have made a number of changes to the ACUMEN Portfolios to do just that. Within developed market equities we took profit on our allocation to the quality factor and rotated into US value stocks which stand to benefit directly from the above rotation. We also took profit on our allocation to companies in the esports and gaming sector (a stay-at-home play) and large cap US technology companies (whose future earnings are heavily discounted by historically low rates) and invested the proceeds into US industrials, materials and financials. Outside the US we also initiated a new position in UK equities, which are attractively valued and should benefit from the ongoing erosion of Brexit uncertainty, a rebound from overly pessimistic dividend expectations and this rotation towards value sectors of the economy.

These trades have performed well since inception, but their ongoing success is conditional on a continuation of the aforementioned narrative.  

In Is The Bond Market Smarter Than The Stock Market, published towards the end of November, we suggested that for the rotation to have legs, we would need to see a continuation of the re-opening story reflected in higher long-dated yields (lower bond prices). As shown in the chart below, that’s exactly what we’ve seen so far.

The question is, can this rise in yields continue, and if so, how far or fast can they go before becoming problematic?

Whilst rising yields aren’t incompatible with rising equity markets, at a certain level, or rate of change, they can be. Indeed, this is what we’ve witnessed recently given the surge in bond yields globally, but specifically in the US where the 10-year Treasury yield rose from around 1.1% to 1.6% in less than two weeks. The severity of the move contributed to a renewed bout of market volatility and the ongoing rotation out of high growth tech (which comprise a large portion of the US indices by market value) and into the value and more cyclical sub sectors of the economy.  

This jump in yields was in-part catalysed by a poorly received 7-year bond auction as investors became increasingly concerned the economy would run ‘hot’ and inflationary fears went into overdrive. Since then we’ve had the February inflation reading, which came in at 1.7%, in-line with consensus expectations. This helped soothe investor concerns as evidenced by the mediocre 10-year auction on Wednesday. As a result, yields have started to fall back and at the time of writing the 10-year is trading around 1.5%. We think yields may continue to fall, out of overbought territory, before testing and bouncing off long-term support at 1.44% and continuing their march higher. This is predicated on the historical relevance of this key technical level, shown in yellow on the longer-term version of the same chart below, and our view that economic growth and inflationary pressures will continue to build into the second half of 2021, as I was fortunate enough to elucidate in this market live Guardian article (you’ll need to scroll down).

So long as the rise in yields is gradual, our base case outlook (for an orderly rotation and melt-up in US equities) remains in play. There are two key risk to this view: (i) if bond yields continue to fall though yellow support (driven by yield curve control and/or price-insensitive buyers) and (ii) if bond yields bounce but do so in a disorderly fashion (driven by a dramatic improvement in the economic outlook and/or rising inflationary pressures). In the first scenario we would look to re-enter some of those newly discounted, yet highly profitable growth names that can continue to perform well over time. The key to this approach will be avoiding the froth that has developed in certain pockets of the growth/tech space. The second scenario harks back to my previous blog, The Unemployment Problem, where we identified a number of potential pinch-points to broader risk appetite, namely: (i) 10-year inflation expectations rising to 2.5%, (ii) the 10-year nominal Treasury yield rising above 2% and (iii) 10-year real yields falling to -0.70%.

Pinch points (i) and (ii) remain quite far off, but real yields, which here comprise both nominal yields and inflation expectations, have risen noticeably over the last month. Quoting from that blog: ‘we think real yields would have to increase by about 35bps before equities start to come under pressure’. Well… real yields in blue have indeed risen by that amount (right hand axis inverted) so that’s another key metric we continue to monitor on high alert status.