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Market Update - Rising Bond Yields

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The stock market has had a volatile start to the year, hitting new highs before being brought lower on rising bond yield concerns. Year to date, the S&P500 is up <green>+3.74%<green>, while the TSX is up <green>+5.33%<green> [1].

Stock Market Volatility

The stock market continues to display its characteristically volatile nature. However, despite this, we do see an improvement in fundamentals. The bullish factors we previously highlighted are helping drive the stock market to new highs.

The most important of these factors is the slowdown of coronavirus infections across the world [2]. The bottlenecks in vaccine supply are being addressed and daily new vaccinations are picking up [3]. There are, of course, still uncertainties related to the virus, such as new strains of Covid-19 that are more resistant to vaccination. However, the overall trend is improving. This, undoubtedly, will have a big impact on the global economy. As lockdowns are rolled back, most economists predict that a strong recovery will follow. The IMF expects the global economy to grow 5.5% in 2021 and 4.2% in 2022 [4]. Moreover, there has been progress on the new U.S stimulus package. The massive $1.9T package recently passed the House of Representatives and is expected to pass through the U.S Senate in March [5]. This adds further optimism to recovery expectations and helps boost investor confidence.

Rising Treasury Yields

However, the expected pickup in economic activity has also led to a new worry for equity investors – namely a rise in longer dated Treasury yields. The US 10-year Treasury has gained 53bps this year [1]. This rapid increase is having a negative impact on equity prices, especially the expensive tech shares with stretched valuations (we explained in our previous newsletter the relationship between bond yields and equity).

Despite the rapid increase in long term rates though, it remains low by historic standards. Furthermore, global central banks have indicated on multiple occasions that they are willing to keep longer term interest rates low to prop up the economy. For instance, the Australian central bank recently announced that it will buy a further $3B in longer dated securities to lower its yield [6]. The Bank of Japan has also hinted that it won’t let its 10-year yields hit 0.3% [7]. Likewise, the US Federal Reserve has plenty of tools to keep rates low if it poses a threat to the nascent economic recovery.

So although bond yields have risen lately, it is likely to remain a manageable risk for the market. Overall, taking all things into consideration, we are still bullish on the market, as the positive tailwind from the fiscal stimulus, the rapid ramp up of vaccinations, and improving economic fundamentals are more than enough to offset the negative impact from rising bond yields.

Caution against Market Speculation

Despite our bullish stance on the market though, we must caution investors against the risks we see. We advise investors to balance their optimism with patience, being mindful that after the big run-up in equity prices recently, purchases should be made prudently. Further, we do see mania and speculation in certain corners of the market, and we warn our clients not to participate in this frenzy. Gamestop (GME) and bitcoin are perfect examples of this. Many have already heard of the GME story. A bullish bet on an internet forum against certain heavily shorted stocks prompted heavy buying in GME. This frenzied buying forced some hedge funds to close their short positions, by buying back shares, which in turn fueled more buying and speculation. However, just as fast as it rose, the shares crashed, as anyone with enough sense could have foreseen [8]. Albeit by itself, GME is insignificant, it is concerning that if this story is repeated often enough, it could potentially erode market confidence and hamper with proper market functioning.

We also see mania in bitcoin and cryptocurrency. Although we do see a potential future where cryptocurrency becomes a more widely adopted form of currency used in transactions, we must warn investors that this does not make it a sound investment as it currently stands. We see classic signs of speculation in this asset class, and although some high profile business people such as Elon Musk have voted their support for bitcoin, we feel smaller investors should not bet on this trend. Some have argued that bitcoin may act as a safe haven and protect against inflation. However, as the asset looks now, its prices don’t show much correlation with inflation expectations and cannot be counted on as an effective long term hedge against inflation [9].

Our Positioning & Looking Ahead

As the world economy recovers, companies should continue to benefit from increasing earnings. Many investors are coming to this realization and are currently overweighting equities and rotating into cyclical stocks, which should enjoy the greatest benefits in a recovering economy.

We have been one step ahead of the herd and have overweighed equities and positioned ourselves in good cyclical names in the selloff last year, thus already making a sizable gain on your behalf. Some of the cyclical and recovery names we’ve bought include Bank of America, Exxon Mobile, CIBC, RBC, among others. We bought these stocks as we believed in the fundamental strength of these companies and believed the market was too myopic at the time. Looking ahead, we believe the foundations for the market are still solid and continue to advise our clients to think long term, invest in sound businesses, and avoid market folly.

1 Factset March 1 2021 Price Return – End of Trading Day