Traders work on the floor of the New York Stock Exchange New York City, on Sept. 28.BRENDAN MCDERMID/Reuters
Rising bond yields clobbered stocks in September, but some market watchers expect that the turbulence could be a good setup for investors betting on companies that can weather an economic downturn.
While investors now believe that the Federal Reserve is going to keep interest rates higher for longer, they have not yet accepted the likelihood of a recession.
“We believe that the U.S. economy has not felt the effects of the monetary tightening that has been put into place, but that will weigh on activity next year,” said Jeff Schulze, head of strategy at New York-based ClearBridge Investments – a part of Franklin Templeton – over a cup of de-caf in Toronto this week.
To be clear, this view is not held by the Fed, setting up a source of friction between the central bank and some of the more skeptical strategists and economists.
The central bank now assumes that U.S. economic growth and employment will remain relatively strong next year, allowing it to maintain interest rates above 5 per cent even as inflation subsides.
It’s an unusual conclusion to a sustained period of aggressive rate hikes by the central bank over the past 18 months. A hard landing characterized by recession and rate cuts are more in line with history.
“If the Fed is right about the economic outlook, then rates can unquestionably stay higher for longer. We just don’t believe those forecasts,” Paul Ashworth, chief North America economist at Capital Economics, said in a note last week.
Canada’s economy flatlined in July, showed little momentum moving forward
Yet investors are believers, according to financial markets: The yield on the 10-year U.S. Treasury bond rose to a fresh multiyear high above 4.6 per cent this week.
Mr. Schulze, like Mr. Ashworth, isn’t convinced that the Fed’s upbeat forecasts will unfold according to plan, though. He thinks the economy is nearing a point at which it decelerates from its current pace of steady expansion and heads toward a recession in the coming year – pushing down bond yields.
The Conference Board’s Leading Economic Index, which reflects readings on factors such as manufacturing orders, consumer expectations and lending conditions, is a key piece of evidence here.
The index has declined for 17 consecutive months, indicating a possible recession over the next year, according to Justyna Zabinska-La Monica, the Conference Board’s senior manager of business cycle indicators.
But Mr. Schulze argued that even a deceleration of U.S. economic growth, without a recession, will likely weigh on bond yields.
“It doesn’t matter whether it’s a soft-landing or a hard-landing. The 10-year U.S. Treasury tends to move lower in whichever economic scenario ends up taking place,” he said.
He’s not expecting a collapse. Instead, he thinks the Fed’s focus on beating inflation – and keeping it down – will leave the yield on the 10-year U.S. Treasury bond at the “mid-to-low” 3-per-cent range, which is a relatively modest pullback from current levels.
Still, declining bond yields could bring relief to the stock market. In particular, Mr. Schulze believes that a retreat will boost the appeal of economically defensive stocks – including utilities and U.S. health care companies, which don’t need a vibrant economy to thrive.
Neither sector has been performing well over the past year, as investors demand higher dividend yields to compete with the income flowing from government bonds, guaranteed investment certificates (GICs) or even money market funds, where investors can find yields of 5 per cent or more.
Within the S&P 500 Index, utilities are down more than 15 per cent over the past year, making it the worst-performing sector over this period. Health care has done better, with a gain of nearly 5 per cent, but it has lagged the index by about 11 percentage points.
In Canada, utilities are down more than 19 per cent over the past year, making them the worst performers within the S&P/TSX Composite Index and frustrating many investors who have turned to these stocks for stability and dividends.
Mr. Schulze thinks that defensive stocks will perform better as the realization sets in that U.S. economic activity is deteriorating.
Indeed, a recent shift in market dynamics may be in the works already. Once-high flying tech stocks, like Apple Inc. AAPL-Q and Microsoft Corp. MSFT-Q, which helped drive the S&P 500 to impressive gains earlier this year, dragged down the index’s performance in the third quarter.
Other stocks, like Target Corp. TGT-N and Best Buy Co. Inc. BBY-N, are struggling in an environment where consumer delinquencies are rising, and shoppers are retrenching.
“So there are some tangible signs out there that, even though the consumer has been resilient up until this point, they may not be able to sustain this spending going forward,” Mr. Schulze said.
It’s not the sunniest view. But it provides a clear game plan when stocks are faltering.