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Welcome to RBC’s Markets in Motion podcast, recorded November 7th, 2023. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Three big things you need to know today:
- First, Growth sectors are typically the biggest beneficiaries of declining 10-year Treasury yields. This analysis was in focus in our meetings last week where investors were keen to explore what to own if yields have peaked.
- Second, Small Caps, where balance sheet concerns have overshadowed attractive valuations, were also in focus in our meetings last week. Friday’s unemployment report also provided another reason to be taking a look at Small Caps now.
- Third, there were a lot of interesting updates in our high-frequency indicators last week, with the most important one being that the deterioration in US equity investor sentiment finally has started to look too extreme. The stock market has had a strong start to November, and the move seems deserved in light of what we’re seeing in most, though admittedly not all, of our sentiment indicators.
If you’d like to hear more, here’s another five minutes. Now, the details.
Takeaway #1: Growth Sectors Are Typically the Biggest Beneficiaries of Declining 10-Year Treasury Yields
The biggest issue on the minds of the equity investors we spoke with in our meetings last week was whether 10-year Treasury yields have peaked. Generally, our view over the last month or so has been that if the surge in yields stopped soon, US equities could escape without incurring too much additional damage. Here’s what we’ve been highlighting:
- First, we highlighted how when the earnings yield of the S&P 500 and the 10-year Treasury yield are close to parity, as has been the case recently, the stock market tends to keep rising. There have been times in the past few decades when this cross-asset gauge of equity valuation has signaled coming declines in the S&P 500, but we didn’t quite reach that level at the October 2023 highs.
- Second, the surge in yields that has occurred since early April 2023 hasn’t been big enough to damage the US equity market too much. Historically, when increases in yields have totaled ~275 basis points or less, stocks have usually posted gains. It’s when the increases are more than that, as was the case in 2021-2022, that stocks tend to fall. The recent surged totaled 168 basis points, unlike the 2021-2022 surge which was more than 300.
- Third, we highlighted how the S&P 500 Communication Services and Consumer Discretionary sectors have the strongest inverse correlation between their performance and trends in yields. These would be two sectors the historical playbook says to buy on a peaking yield thesis. We see better valuations in Communication Services than Consumer Discretionary. Within Small, Health Care is the sector that tends to be most negatively affected by higher rates and should benefit if the peak has been seen.
Moving on to Takeaway #2: Small Caps Are Another Beneficiary of Declining Interest Rate Angst, and Rising Unemployment Actually Helps Make the Case To Look at Them Now
- The state of Small Caps was also in focus in our meetings last week.
- We have been highlighting how angst around interest rates has been the main challenge that Small Caps have faced recently.
- Small Caps tend to underperform when the Fed is tightening, and outperform when the Fed is easing, but the easing cycle has felt far off as investors have debated whether another hike is coming in December.
- We’ve been reminding investors that Small Cap balance sheets are in better shape than feared.
- For the average Russell 2000 company, the weighted average maturity is about 4.5 years. To the extent that there is a maturity wall Small Cap companies are about to run into, it’s in the 2-5 year window, not anytime soon.
- Additionally, the effective interest rate that Small Cap companies are paying is still near historical lows. Small Cap companies, just like their Large Cap peers, have increased exposure to long-term debt in recent years.
- Of course, interest rates aren’t the only potential driver of Small Cap performance trends. Friday’s jobs report was also particularly interesting from a Small Cap perspective. It showed that the unemployment rate moved up noticeably. Prior to the financial crisis, we often saw Small Cap performance start to inflect positively relative to Large Caps around the same time that the unemployment rate moved up. Sometimes the turn in Small Cap relative performance came ahead of the pivot in the unemployment rate, other times it came a bit after.
- This chart is a good reminder that Small Caps tend to price in economic problems ahead of time.
Wrapping up with takeaway #3: an important shift in sentiment.
- The biggest thing that jumped out on our high frequency indicators last week was that net bulls in the AAII survey finally reached levels suggesting pessimism in equity markets may have gotten too extreme.
- In last week’s update, net bullishness fell to 2 standard deviations below the long-term average on the weekly data point and to 1 standard deviation below the long-term average on the four-week average. From these kinds of levels, the S&P 500 is typically up about 14% over the next 12 months.
- Does this mean we are out of the woods for 2023? No, but it’s a promising data point for the year ahead.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.