Stocks drop as strong economic data cause bond yields to surge

The stock market goes up or down, and you can’t adjust your portfolio based on the whims of the market, so you have to have a strategy in a position and stay true to that strategy and not pay attention to the noise that could surround any particular investment. – John Paulson

After a strong start to the week that saw the Dow Jones Industrial Average reach an all-time high, the stock market reversed course and closed slightly lower due to a sudden rise in bond yields. The Nasdaq Composite Index fared much worse with a loss of over 3% as previously high-flying technology stocks like Amazon, Apple and Alphabet (Google) came down to earth. The week began on a positive note when the U.S. and Canada reached a trade agreement to replace the current North American Free Trade Agreement (NAFTA). The new agreement will be called the U.S. – Mexico – Canada Agreement (USMCA) and should be an improvement that will benefit all countries. Before investors could celebrate the new agreement, though, the yield on the 10-year Treasury jumped from 3.06% to 3.23% at week’s end, causing stocks to tumble. There were several reasons for the spike in the yield, not the least of which were comments by Federal Reserve Chairman Jerome Powell. He remarked that the Fed has a long way to go before interest rates hit neutral, implying that there will be many more rate hikes in order to normalize monetary policy. The ADP jobs report on Wednesday, a precursor to the government employment report, also may have spooked investors as it showed that 230,000 private sector jobs were created in September, the highest level in seven months. On the same day, the ISM non-manufacturing or services sector index reached its highest level since the index was created back in 2008. More concerning than the absolute level of bond yields was the fast pace of the move, 17 basis points (a basis point is one hundredth of one percent) in one week. In the process, the yield curve also steepened with the 2-year Treasury yielding 2.88% and the 10-year Treasury yielding 3.23%, more indicative of a strong economy that shows little or no sign of an imminent recession. It was no surprise that financial and bank stocks performed well last week under this scenario and it will be the financials that will headline the beginning of third quarter earnings season this week.

Last Week

Although the September employment report showed that only 134,000 new jobs were created, far below the estimate of 185,000, the number was misleading. Both the July and August job numbers were revised substantially higher and the unemployment rate fell to 3.7%, the lowest level since 1969. Wage growth also was in line with estimates and not considered inflationary. The September ISM manufacturing index remained at a high level as demand continues to be strong. U.S. factory orders in August were also slightly better than expected.

For the week, the Dow Jones Industrial Average fell 11 points to close at 26,447 and the S&P 500 Index dropped 1% to close at 2,885. The Nasdaq Composite Index plunged 3.2% to close at 7,788.

This Week

Investors will get a good read on inflation this week as the September producer price index (PPI), consumer price index (CPI) and import prices are all due to be released. All three are expected to increase by only 0.2%, a sign that inflation remains contained for now. The October University of Michigan consumer sentiment index is expected to be at a high level consistent with the strong reading in September.

The third quarter earnings season begins this week and the financials will be the first sector out of the gate. The companies scheduled to report include Citigroup, Wells Fargo, PNC Financial Services and JP Morgan Chase along with non-financial names that include Walgreens Boots Alliance and Delta Airlines.

Portfolio Strategy

What a difference a week makes. That is the time that it took investors to go from concerns over a flattening yield curve and possible inversion to a steepening yield curve and fears of still higher interest rates. An inverted yield curve occurs when short-term interest rates exceed long-term interest rates, a condition that has predicted a recession each time dating back to 1975. The difference between the 2-year Treasury yield and the 10-year Treasury yield was only 24 basis points at the end of the third quarter, but that gap widened to 35 basis points by the end of last week. A strong economy, a solid labor market and better than expected corporate earnings have shifted the narrative and caused investors to rethink their fixed income strategy. So far this year, long-term Treasuries are down about 9%, intermediate-term Treasuries have lost about 2.5% and short-term Treasuries have been basically flat. Other fixed income investments, such as high quality corporate bonds, mortgage-backed securities and municipal bonds, have also posted slightly negative returns on a year-to-date basis. High yield bonds, which are riskier due to their low credit quality, are up about 1% for the year as their 5% plus yields have more than compensated for their decline in price. (Bond prices and yields move in opposite directions.) The best way to protect a fixed income portfolio against rising interest rates is to shorten the average duration and maturity of the bonds and to emphasize higher-quality issues. Longer term, as bonds mature in fixed income funds and are replaced with higher-yielding bonds, the overall yield of the fund will increase and provide a higher income stream.