A storm is brewing as bond yields surge

The recent deluge of rain on the East coast of Australia had devastating impacts. While the extent of the damage was unpredictably extreme, meteorologists knew beforehand that heavy rains were expected, given their association with the La Nina climate pattern. In a similar analogy, stock markets also have seasons that cycle between bull and bear markets. Understanding the market environment is extremely important for a volatile asset class like equities.

In January 2022, spiking global bond yields led to significant share market corrections across the world. In Australia, the ASX300 Accumulation Index had its first serious correction (-6.5%) since the COVID crisis in 2020. This was the first clear sign that share markets do not like rising interest rates. In fact, storm clouds have been brewing over markets for some time and investors should brace themselves for increased volatility in the months ahead.

Before Russia invaded Ukraine in February 2022, the world was heading into another economic slowdown. Earnings growth peaked in mid-2021 and has since been decelerating.

Source: FactSet

Periods of slowing economic growth typically lead to negative earnings revisions. And weak earnings set the foundation for increased share market volatility. At Vertium we call these periods ‘down market regimes’ as the frequency of down months and the chance of significant market corrections increases. 

Source: FactSet

Unlike previous economic slowdowns, the recent COVID crisis has stoked inflation from its slumber. Reckless government spending and supply chain issues led to rampant inflation including electronics, cars, and houses. Two years after the onset of the COVID pandemic, the inflation outlook was gradually easing as lockdown restrictions were ending. However, the Ukraine invasion in February sent inflation expectations soaring. COVID inflation was then superseded with CONFLICT inflation of everything we cannot live without such as oil and food. The spike in inflation has led to one of the steepest bond sell-offs in history. In the United States, the surge in bond yields has reduced the valuation margin of safety between equities and bonds to an extremely low level in the post-Global Financial Crisis period.

Source: FactSet

Short-dated interest rates have surged even further as the US Federal Reserve (Fed) is expected to aggressively raise rates to fight inflation. The speed and magnitude of rate hikes expected is so high that it is on par with the 1994 Fed cycle that led to a period dubbed the ‘Great Bond Massacre’.

While the current expected rate cycle looks very similar to 1994, the economic backdrop is very different. In 1994, inflation was tame, and the Fed raised rates early when economic activity (proxied by the US ISM manufacturing index) was recovering from its trough in the prior year. In 2022, inflation is extremely high and economic growth is slowing from its peak in 2021. The Fed left raising rates so late that it is now stuck between a rock and a hard place – it is trying to tame inflation in a slowing economy. They are going to hike rates until something breaks.

Source: FactSet

Raising rates aggressively is a tax on the economy but so is a rapidly rising oil price. The surge in the oil price due to the Russian invasion of Ukraine is on par with previous oil price spikes (above its trend). Historically, oil price surges do not provide a good omen as it has coincided with recessions.

Market internals are also highlighting that something is not right with the skyrocketing bond yields. For example, the performance of US bank stocks typically has a positive correlation with interest rates as their profits are expected to improve when their net interest margin expands. However, despite rising rates they have recently underperformed the market. This is possibly another sign that the economy may not be as strong as it seems.

Source: Iress

The same divergence with rates also occurred in late 2018 when banks underperformed as the market was obsessed with reflation and ‘bondcano’ narratives. Economic gravity eventually prevailed with the 2018 slowdown. Will 2022 bring a similar outcome or worse?

Conclusion

Summer is well and truly over with the COVID melt-up in distant memory. Storm clouds are on the horizon as the current economic outlook is less sanguine than a year ago. Global growth has peaked, and fiscal stimulus has ended. Easy monetary conditions have also ended, with QE tapering around the corner and many countries around the world raising interest rates. And inflation is surging at a time when growth is slowing, creating stagflation. This challenging environment is not healthy for volatile assets and Vertium is well prepared for the wind and rain ahead.

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