In today’s Exponential Investor:
- Bailey and Powell: not saying the same things at all
- Why rising bond yields have had a greater impact on the US stock market
- How the FTSE indices have fared even as gilt yields have soared
As of last week, a number of the biggest tech stocks in the United States were well below their recent/all-time highs, as shown by Charlie Bilello on Twitter:
- Microsoft: -9%
- Google: -11%
- Apple: -12%
- Tesla: -12%
- Facebook: -15%
- Amazon: -16%
- Shopify: -22%
- Twitter: -28%
- Roku: -40%
- Spotify: -44%
- Peloton: -53%
- Zoom: -57%
- Alibaba: -57%
But since early September, as UK yields have soared, the FTSE 100 hasn’t suffered too much. Here is the one-month chart of the FTSE (red) vs the S&P (blue):
What’s going on here? And what’s it got to do with a dinner speech, and an interview with the Yorkshire Times?
Different central bankers, different scripts
Well, on Tuesday I wrote to you about Andrew Bailey’s comments last weekend.
He’s the governor of the Bank of England and has been saying some interesting things about inflation and central bank monetary policy.
It is especially intriguing when you compare his statements to those of his American counterpart, Federal Reserve chair Jerome Powell.
And they might go some way to explain why US tech stocks are struggling, while the UK stocks have remained comparably stable.
Given that these two men essentially control the price of money in the UK and the United States, it’s worth trying to understand what the differences are, what effects they are having and why they might be diverging.
Mr Powell is committed to more stimulus for longer, and lower interest rates for longer, and the fortunes of the US stock market just happen to be highly dependent on those two things.
A slump in the US stock market would likely have an adverse effect on economic activity in the United States.
As a result, Mr Powell has been firm on the idea that current inflationary pressures will be “transitory” and are nothing to worry about.
In the UK meanwhile, Mr Bailey is more concerned about inflation, and has shown more willingness to raise rates sooner.
As it happens, the UK’s stock market is dominated by stocks that are far less sensitive to moves in interest rates and bond yields than the largest US stocks.
How bonds can drive stocks
This is important to understand, because much of the prevailing narrative is that higher rates will be terrible for stocks.
This is because as bond yields rise, investors can (in theory) get a better return for less risk by investing in bonds. So some money will move from stocks to bonds.
It is also the case that because equities are generally seen as being riskier, there is something called the “equity risk premium”.
If, by way of example a bond yields 0.5%, investors might accept a return of 4% on their stock investments. In this case, the equity risk premium is 4% less 0.5% or 3.5%
But if bond yields rise to 2%, as they are threatening to do in the United States, then equity investors would want a return of 5.5% (i.e. 2% plus 3.5%) on their stocks to compensate for the added risk above investing in a bond.
Everything else being equal, stock prices will fall in this situation – so that the dividend yield on (and the total return from) stocks rises.
For much of the last 40 years, falling bond yields have contributed to rising stock prices in much of the world.
In the United States, technology, software and growth companies dominate the major stock market indices. Their valuations are sensitive to moves in bond yields. As noted, the share prices of many of the largest names have suffered over the last six months or so as Treasury yields have risen off their post-pandemic lows.
Here in the UK, the FTSE indices are dominated by large and established companies – often in areas like financial services, energy, healthcare and construction. Their valuations are not so sensitive to moves in bond yields.
Looking at the very long term, we can see that as rates (on the US 10-year bond, in purple) have fallen dramatically in the last 25 years, the US stock market (blue) has benefitted much more than our own FTSE 100 (red).
So, bond yields really are important. And bond yields that are rising from very low levels can pose a threat to stock markets.
However, this is truer in the United States than in the UK.
This could go a long way to explaining why Mr Bailey is happier to talk about raising rates and cutting back on stimulus sooner, than his opposite number at the US Federal Reserve.
The chart below, which has two different scales on the Y-axis to show the longstanding correlation and recent divergence, shows the incredible surge in the UK yields in the last couple of months.
The yield on the UK’s 10-year gilt bond (in red) is at a its highest since March 2019. The post-Covid lows are a distant memory.
Meanwhile, in the United States, the yield on the 10-year Treasury bond (in blue) is not quite at a post-Covid high, and still at the same level as in January 2020, just before the pandemic struck.
For the first time since mid 2016, around the time of the Brexit referendum, the 10-year gilt yield (1.2%) in the UK is threatening to catch up with the 10-year Treasury yield (1.6%).
As noted, it is significant that the UK stock market has been quite resilient in recent months.
Another reason why yields matter
In the meantime, the movement in yields on Treasury bonds in the United States have had an impact on the relative performance of different parts of the US stock market.
The chart below tells the story.
The dark blue line shows the yield on the 10-year Treasury bond.
The red line shows the performance of an exchange-traded fund (ETF) which invests in growth stocks relative to the overall US stock market.
Growth stocks are companies – like many that are listed at the beginning of this report – which are expected to expand profits rapidly and which are priced at levels which, by many benchmarks, are high.
The light blue line shows the performance of an ETF which invests in value stocks relative to the overall US stock market.
Value stocks tend to be established companies that are expected to grow at a moderate pace. Often dividends represent an important component of total returns to investors. Such companies feature prominently in the UK stock market.
When the yield on the 10-year US Treasury bond is rising, that should be good for the relative performance of value stocks, and bad for the relative performance of growth stocks.
The converse is true when the yield is falling.
See how in January this year, growth stocks (red line) outperformed briefly at the start with yields (bright blue line) falling, before the big rise in yields got going (as inflation concerns grew in spring).
With yields rising, it was value stocks (pale blue line) which outperformed until the middle of the year.
Then, when yields fell again in July and August, growth outperformed once more.
The bottom line is this: in theory and in practice, different kinds of stocks will not respond in the same way to any given move in bond yields.
All the best,
Editor, Exponential Investor