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Spike in 10-year Treasury yield roils markets, S&P 500 down 2.5%

While it might seem that anyone can be a value investor, the essential characteristics of this type of investor – patience, discipline and risk aversion – may well be genetically determined. – Seth Klarman

A spike in the 10-year Treasury yield to 1.6% roiled the markets last week as all three major stock averages closed lower, with the Nasdaq Composite Index shedding nearly 5%. The S&P 500 Index fared better and lost about 2.5% for its second straight weekly loss. Although the yield on the 10-year Treasury settled at 1.44% on Friday, the damage had already been done as investors fear that rising inflation and interest rates could undermine stock valuations that are stretched, especially in the technology sector. This concern was the only real negative last week as economic data continued to be positive and fourth quarter earnings were mostly better than expected. There also was good news on the fiscal stimulus bill and vaccines for the coronavirus. Over the weekend, the House passed a $1.9 trillion economic relief package that now moves to the Senate for its approval, although much of the bill is not related to Covid-19. The Food and Drug Administration (FDA) also endorsed a single-shot vaccine from Johnson & Johnson, making it three vaccines now available in the U.S. While the market fears that a stronger economic recovery coupled with more stimulus may lead to higher inflation, the Federal Reserve is more sanguine. Fed Chairman Jerome Powell in his testimony before Congress said that inflation is still “soft” and that the economic outlook is still “highly uncertain”. He also said that the economy is a long way from realizing its employment and inflation goals and that it will take time for meaningful progress to be made. The Fed seems committed to its easy monetary policy and is not concerned about the threat of inflation, which the Fed firmly believes it can fight with the monetary tools at its disposal. Powell said that it may take three years for inflation to reach its target of 2%. As a rule, rising bond yields reflect growing confidence in an economic recovery, which makes sense given the declining number of Covid-19 cases and the continued rollout of vaccines. As long as this translates into stronger corporate earnings, the market should be able to handle higher rates.

Last Week

Leading economic indicators in January were better than expected and the second estimate of gross domestic product (GDP) in the fourth quarter was 4.1%, slightly better than the initial estimate. Durable goods orders in January were also strong as they topped orders in December and were triple what economists had forecast. Weekly jobless claims totaled 730,000, compared to expectations of 845,000. Finally, the personal consumption expenditure (PCE) index, the Federal Reserve’s preferred measure of inflation, rose slightly more than expected but has risen only 1.5% year over year through January.

For the week, the Dow Jones Industrial Average fell 1.8% to close at 30,932 while the S&P 500 Index dropped 2.5% to close at 3,811. The Nasdaq Composite Index declined 4.9% to close at 13,192.

This Week

The February employment report is expected to show that about 200,000 new jobs were created and that the unemployment rate edged higher to 6.4% from 6.3%. ADP releases its National Employment Report and it is forecast to show an increase of 230,000 private-sector jobs. Both the ISM Manufacturing and Services Purchasing Managers’ Indices (PMI) for February are expected to be nearly 59, about even with January and well above the 50 threshold that indicates expansion. January construction spending is also forecast to be modestly higher as construction spending has fully recovered from the pandemic and is at an all-time high.

The Federal Reserve releases its beige book that surveys current economic conditions in each of the 12 Federal Reserve districts.

The most notable companies scheduled to report quarterly earnings this week are Zoom Video Communications, Hewlett Packard Enterprise, Broadcom, AutoZone, Target, Dollar Tree, Costco Wholesale, Gap, Kroger, Burlington Stores, Kohl’s and Nordstrom.

Portfolio Strategy

Although the yield on the 10-year Treasury ended the week at 1.44%, the spike in the yield to 1.60% on Thursday caught investors by surprise and served notice that inflation expectations are rising, which might portend higher yields as well. (Bond yields move inversely to prices with higher yields meaning lower prices). The prevailing view is that the economy is gaining strength and the recovery should accelerate as the number of coronavirus cases has been steadily declining while the number of people being vaccinated has been increasing. The fear among investors is that the likelihood of a $1.9 trillion fiscal stimulus bill being passed is getting greater, which has heightened concerns that it may be inflationary. Growth stocks, such as those in the technology sector, were hit the hardest last week as the Nasdaq Composite Index plunged nearly 5%. These stocks had been the best performers but also were the most expensive and are particularly vulnerable in a rising interest rate environment. So far this year, there has been rotation out of these growth-type companies into more value-oriented, economically sensitive companies that typically have lower valuations and above-average dividend yields and are in a position to benefit from an improving economy. The 10-year Treasury was below 1% at the start of the year and many economists forecast that this yield would be at about 1.50% at the end of the year, not at the end of February. Recent economic data has been mostly positive and the February employment report to be released this week bears watching. Federal Reserve Chairman Jerome Powell is also scheduled to speak this week along with other Fed officials and it is hoped that the sudden spike in bond yields will be addressed. In the meantime, investors should maintain a relatively short average maturity structure in their fixed income portfolios to guard against the possibility of continued higher interest rates.