CONTRIBUTORS
Jeffrey Schulze, CFA
Head of Economic and Market Strategy
Josh Jamner, CFA
Investment Strategy Analyst
Key takeaways
- With the Federal Reserve (Fed) rate-hike cycle at or near its conclusion, in our view, the 10-year U.S. Treasury yield is likely to stabilize and decline in the coming year, supporting equity market valuations and influencing leadership.
- Bond yields typically track the direction of economic momentum, with higher yields accompanying an improving outlook and lower yields signaling deceleration. With a widely followed economic surprise index hitting its top decile earlier this summer, we would not be surprised to see it roll over and bring yields down in the process.
- Equities with defensive and growth characteristics tend to be relative beneficiaries from declining long-term yields, leading us to favor companies with these traits.
Regardless of macro outcome, yields have likely peaked
After embarking upon the most dramatic pace of tightening in two generations, the Fed may finally be nearing the completion of its hiking cycle. Historically, equities tend to follow a similar pattern in the period leading up to the final rate hike. However, their performance following the last rate hike has a much wider range of outcomes depending on whether the economy falls into a recession or skirts by with a soft landing. Our base case continues to be a recession—a view driven by the continued recessionary red signal from the ClearBridge Recession Risk Dashboard—although the jury is still out on how this story ends. There are no changes to the dashboard this month.
Exhibit 1: ClearBridge Recession Risk Dashboard
Source: ClearBridge Investments.
Regardless of which path the economy takes, the 10-year Treasury yield has likely already made or is near its peak. The 10-year rose over 100 basis points from its April lows to its recent high in August, with just over half of that occurring between mid-July and late August. History suggests this move may be nearing its end. The 10-year Treasury yield typically peaks around the time of the final rate hike, with a range of four months prior to five months following the peak in the fed funds rate. If history is a guide, the 10-year is likely to stabilize and decline in the coming year, which would have important ramifications for equity valuations and market leadership.
Exhibit 2: Peak Fed, Peak 10-Year
Source: Federal Reserve and Bloomberg. Past performance is not an indicator or a guarantee of future results.
Declining long-term interest rates bode well for equity market valuations because future cash flows are discounted by a smaller amount. In effect, the value assigned to future profits rises as the discount rate declines, increasing the theoretical value of an asset despite no change in the underlying cash flows. At 18.8x next-12-month earnings, the S&P 500 Index can hardly be described as “cheap” on a valuation basis. However, if the 10-year Treasury yield—and discount rates by extension—decline from here, the market multiple would look less stretched than it currently does with the 10-year yielding more than 4%.
Beyond the general level of valuations, bond yields can also influence market leadership, as evidenced by the market’s recent choppiness. Generally, equities with defensive and growth characteristics tend to be relative beneficiaries from declining long-term yields, while cyclical and value stocks tend to hold up better as rates ascend. As the 10-year rose sharply from late July through late August, sectors like utilities (defensive) and information technology (growth) underperformed while energy (cyclical) and health care (value) outperformed.
This dynamic occurs for several reasons. Firstly, lower bond yields tend to signal decelerating economic momentum. The 10-year Treasury yield closely tracks changes in the Bloomberg Economic Surprise Index, which measures the frequency with which data releases are beating (positive) or missing (negative) expectations. Lower yields tend to be associated with slower economic growth, meaning equity investors tend to seek out companies with more resilient earnings profiles and attractive dividend yields, like defensives. By contrast, higher yields tend to accompany an improving economic outlook, which typically boosts the cash flows of cyclical companies to a greater degree. At the same time, investors can find more attractive yields in fixed income, further diminishing the appeal of defensives relative to cyclicals. With the Economic Surprise Index hitting its top decile earlier this summer, we would not be surprised to see it roll over, bringing 10-year yields lower in the process.
Exhibit 3: Bond Yields Move with Economic Momentum
Data as of Sept. 1, 2023. Source: Federal Reserve and Bloomberg. Z-score is a statistical measurement that describes a value's relationship to the mean of a group of values. Past performance is not an indicator or a guarantee of future results.
A second way interest rates impact equity leadership is related to the discount rate dynamic outlined above. Growth stocks tend to have a greater emphasis on cash flows further in the future. As a result, those equities tend to be punished more as the discount rate rises and the value of those future cash flows is reduced. By contrast, value stocks tend to be priced on cash flows occurring in the next few years, making them relatively less susceptible to changes in the discount rate.
Importantly, the S&P 500 has become more dominated by companies with growth and defensive characteristics in recent years, while the share of cyclicals and value has declined. This is hardly a new phenomenon, in fact, this trend has been gaining strength for the last 100 years. Today, the share of the S&P 500 that can be classified as growth, stability and defensive is over 70%, up from 60% 10 years ago and 40% almost 100 years ago.
Exhibit 4: Index Composition Supports Higher Price-to-earnings Ratio
Data as of August 31, 2023. Source: Cornerstone Macro, FactSet, S&P. Past performance is not an indicator or a guarantee of future results.
This means the benchmark has become more sensitive to changes in bond yields than in the past. If bond yields are nearing or have reached a peak, lower rates could help support valuations in a soft-landing scenario or blunt some of the pain for equities in a recession. Just how much Treasury yields may fall is an open question.
Conceptually, yields can be decomposed into three pieces: inflation expectations, economic growth and the term premium. The term premium is the additional compensation investors require, above and beyond the growth and inflation components, to lend their money for longer periods. Following the Global Financial Crisis, the term premium collapsed and was deeply negative at times with investors flocking to the safety of Treasuries. More recently it has risen, and investors may ultimately decide that additional compensation is required, particularly given the renewed uncertainty around inflation and the large deficits the U.S. government continues to run.
We think this cycle's potential rate decline could be more truncated compared to history. Even so, we continue to believe equity leadership should be marked by defensive and growth tilts, with those characteristics being more leveraged to declining bond yields (regardless of magnitude) which we believe are on the horizon.
Definitions
The ClearBridge Recession Risk Dashboard is a group of 12 indicators that examine the health of the U.S. economy and the likelihood of a downturn.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
The Bloomberg Economic Surprise Index measures whether agents are more optimistic or pessimist about the real economy than indicated by actual data releases.
The price-to-earnings (P/E) ratio is a stock's price divided by its earnings per share.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.