The stock market does not necessarily track economic cycles. The stock market anticipates changes in economic cycles, or at least attempts to do so. Financial markets such as stocks and interest rates predict changes in the economy three to six months ahead of the actual change in the economic cycle. Stocks and bonds will bottom well in advance of an economic recession and top months or quarters in advance of the onset of an economic peak.
Investors and traders need to understand the relationships between the financial markets and the economic cycles. Spotting changes in the stock market and forecasting the different economic cycles are challenging. For instance, the NBER, the foremost expert and quasi-official arbiter of US economic cycles, has been known to call an end to a recession more than a year after the actual occurrence.
So, what is interest rates telling us about the state of the US economy, market leadership, and sector rotations?
The US economy is moving toward the Mid-cycle phase of the US business cycle. Mid-cycle tends to be the lengthiest phase of the business cycle, denoted by positive but moderate growth. Business activities continue to be strong; credit markets are healthy; corporate profits are solid, and the Fed monetary policies remain accommodating but tilting toward a neutral stance.
As the economy enters the Mid-cycle phase, stock market corrections are frequent. Sector rotations are violent, resulting in the tightest sector performance differentiation of any business cycle. Money managers and sector allocators tend to be stock and sector-selective.
Interest rates may play an intricate role in investment performances. The bottom line on interest rates and investments trends are as follows. When interest rates rise, bond prices tend to fall, there is the potential for stock market losses, higher interest rates on savings accounts and CDs, commodity prices decline, and mortgage rates rise. When interest rates fall, bond prices tend to rally higher, there is the potential for stock market gains, lower interest rates on savings account and CDs, commodity prices rise, and mortgage rates decline.
History suggests higher rates can temporarily disrupt stocks and often cause severe sector rotations, at least from a near-term perspective. However, higher rates have led to higher and not lower stock prices, at least from a longer-term basis. Stock valuations and stock prices are likely to trend higher than trend lower when rates are rising from abnormally low levels, as is the case today.
It is more complicated than this. During the 1970s and early-1980s, the higher rates coincided with lower valuations and poor stock market valuations and returns. At current levels, the case for stocks and rates moving together may depend on interest rates adjusted for inflation and multiples moving together.
So, does a change in the interest rate environment lead to changing sector and style preferences?
A review of the 10-year US Treasury yield (TNX – 1.481%) and several ratio analyses of sectors may uncover the role of interests rates and stock performances.
Surprisingly, TNX is trading at the same level as earlier in the year (February). Over the past ten months, TNX has fluctuated widely within a sideways trading range between 1.128% (7/20/21 low) and 1.765% (3/30/21 high).
In the new year (2021), the dominant and prevailing market call was to overweight cyclical and economically sensitive sectors in anticipation of the economy reopening. As interest rates rallied higher, the Consumer Cyclical sector (XLY) outperformed the Consumer Staples sector (XLP). The S&P Growth index (SGX) also outperformed the S&P Value index (SVX), and S&P Technology (XLK) outperformed S&P Financial (XLF).
However, as TNX peaked at 1.765% on 3/30/21 and began to decline, it led to cyclical and value-related sectors falling or trading sideways and growth sectors such as Technology rallying and outperforming their counterparts.
TNX would bottom at 1.128% and 1.129% during 7/20/21 and 8/4/21, respectively. The ability of TNX to find support here led to another rally in value sectors and cyclical sectors as the ratios rebounded before rates again peaked in late October at 1.691% and once again in late November at 1.693%. In the past two months, rates have declined again, favoring Technology and Growth once again.
Based on the recent Fed's shift in monetary policy toward an accelerated pace of tapering and hiking rates during 2022, many investors expect interest rates (TNX) to trend higher. As TNX moves above 1.691-1.693% (October/November 2021 highs) and breakout above 1.765% (March 2021 highs), will value outperform growth, Financials outperform Technology, and Consumer Cyclicals outperform Consumer Staples?
On the other hand, if TNX continues to decline toward pivotal support at 1.128-1.129% and breaches this low, will this also reaffirm the resumption of the leadership favoring Technology and Growth over Financials and Value.
If you want to understand sector rotations and the debate on the growth/value investment styles, then pay greater attention to the 10-year Treasury yield next year.