Remember the “can’t lose” conjuncture?
It’s a pretty simple dynamic. Secular growth, including mega-US tech, benefits in an environment characterized by falling bond yields and growth concerns. Because mega-tech comprises such an outsized share of benchmarks, a defensive tilt in equities can perversely manifest in record highs for the “broad” market, with the scare quotes there to indicate that “broad” is a misnomer.
So, when a growth scare comes calling (e.g., predicated on Delta variant concerns or Fed “policy mistake” innuendo), any attendant decline in bond yields and/or bull flattening impulse in the curve, bolsters the names which play Atlas to the benchmarks (figure below).
That’s one part of the “can’t lose” dynamic.
The other side of the coin is growth optimism (i.e., the opposite of a growth scare) in which case the reflation trade takes the baton, as market participants’ faith in the “economic renaissance” narrative is renewed.
Either way, stocks win.
That’s a gross oversimplification, of course. There are myriad things that can go wrong. For example, if yields fall too quickly (amplified by a position squeeze, for example), a growth scare can begin to look like a growth panic, in which case risk assets get hurt. Or, conversely, bonds can sell off too rapidly, offsetting the good economic vibes associated with a gentle rise in yields.
Implicit in the scenario that finds equity benchmarks making new highs as falling bond yields bolster heavily-weighted growth shares is solid performance for balanced portfolios and risk parity. Although an all-stocks “portfolio” will obviously run away from both during periods when benchmarks refuse to correct even by a modest 5% (periods like the current stretch), Goldman noted that “outside of the large drawdowns in Q4 2018 and Q1 2020, balanced equity/bond portfolios have performed remarkably well since 2019, supported by 10-year TIPS yields falling from c.116bps at the end of 2018 to -120bps in early August.”
In a note out earlier this week, the bank’s Christian Mueller-Glissmann recapped the dynamic described here at the outset, noting that it’s produced a “widening gap between S&P 500 returns and changes in US 10-year yields.” The figure (below) makes the point. I’ve used it before, but updating it shows the disparity has indeed grown.
“The current equity-bond yield disconnect has been due to the boost to long-duration secular growth stocks from further declines in real bond yields,” Mueller-Glissmann went on to say, reiterating that “this helped broad indices, which now often have a larger weight in those stocks.”
There’s a kind of paradox within a paradox here, when you consider that rock-bottom bond yields are one rationale for buying stocks at elevated multiples. And yet the “disconnect” between equity benchmarks at records and bond yields ~40bps below this year’s highs, is often characterized as something that needs to “resolve,” either by stocks falling dramatically, yields rising rapidly or the two meeting somewhere in the middle.
“While this gap might linger for longer or close in a ‘friendly’ way, with bond yields gradually increasing, the risk of a correction in the event of either a rate shock or a growth shock has increased,” Goldman went on to say, noting that the bank recently downgraded their outlook both for the US and Chinese economies. Mueller-Glissmann also cited recent stumbles for commodities, and warned that “there are rising concerns of rate shock risk” as the Fed prepares to unveil a taper timeline at some point over the next several months.
You might be asking yourself if this relatively cautious cadence is compatible with the bank’s house view on stocks and bonds. The answer is… well, the answer is that Mueller-Glissmann adds caveats to account for David Kostin’s bullish S&P target and the bank’s expectation that any taper-related indigestion in rates will be “relatively benign” and “more muted” than the infamous 2013 tantrum.
Still, he said “the combination of weaker growth with policy tightening and higher real yields increases the risk of a ‘Balanced Bear’,” where that’s just a cute name for a drawdown in stock-bond portfolios. For those interested, Goldman recommended selling bond upside or rate receivers to fund downside protection for stocks.
