Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Good start to Q4 earnings and our hypothesis of interest rate sensitivity
Peter Garnry
Chief Investment Strategist
Summary: A bit more than 10% of the companies in the S&P 500 have reported earnings and so far the numbers are better than expected underscoring the continuing improvement in corporate profitability despite the ongoing pandemic and severe restrictions on mobility in the developed world. In today's equity update we also lay out our hypothesis for the interest rate sensitivity which we believe has gone dramatically over the years and is one if the most important risk sources in the equity market. We also explain the dynamics we expect to see before rising interest rates hit the speculative growth segment in equities.
Around 55 companies have reported Q4 earnings in the S&P 500 and the earnings surprise ratio is so far 90% while the positive revenue surprise ratio is 74%. In terms of revenue growth, the best sectors are consumer staples helped by stimulus checks and the health car and IT sectors. In the bottom of the revenue growth ranking we find energy and industrials. It is still early days, but the numbers so far indicate a good Q4 earnings season despite a more negative backdrop with the new lockdowns and restrictions in the developed world. The few earnings releases that we have got in Europe have so far also been to the positive side.
As we showed on Monday in our Q4 earnings week preview, earnings growth was stagnating before the pandemic and on a longer horizon since the financial crisis earnings growth is only barely positive for MSCI World in nominal terms. In other words, the lower discount rate is the key catalyst that has supported rising equity valuations and sustained the bull market. Our hypothesis is that the interest rate sensitivity in the equity market has gone up as we talked about in our note Democratic sweep, interest rate sensitivity, and reflation from 6 January.
The problem is that it is difficult to quantify as the long-term relationship is that higher interest rates come with higher equities (opposite of our hypothesis). One of the reasons for this relationship is that we have had 40 years of lower inflation and thus most periods of rising interest rates have been that of higher growth and less about inflationary pressures. Secondly, if we shorten the time period we look at, say only look at 2020 data, then the unusual market moves and big data outliers during the February and March selloff again makes it difficult to quantify our hypothesis.
Despite this we are still guessing that the interest rate sensitivity has gone up for two reasons. One, it explains the higher equity markets given the low earnings growth. Secondly, the significant increase in equity valuations of growth stocks with no earnings or expected cash flows far into the future have one of the best performing segments since rates began dropping in last 2018 until the pandemic hit the economy. But when will the market reach an inflection point on rates and impact the most speculative growth stocks (read our note Bubble stocks go into ‘hyperdrive’ mode)? So far, the 60 basis points move in the US 10-year yield since early August 2020 has not dented growth stocks. If growth expectations (see chart) measured by dividend futures on 2022 dividends are rising fast the higher discount rate is most likely cancelled by the opposite force of higher growth. When growth expectations slow and we still see higher interest rates coupled with higher inflationary pressures (energy prices, China PPI etc.) then the higher discount rate is the toxic one and we expect to see a negative to growth equities.
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