Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Democratic sweep, interest rate sensitivity, and reflation
Peter Garnry
Chief Investment Strategist
Summary: The Democrats have most likely secured two additional Senate seats in the Georgia runoffs giving the party a Congress majority with the tie breaker vote from the Vice President elect. This changes the macroeconomic outlook quite a bit which is also evident in today's session with interest rate climbing together with inflation expectations, US technology stocks adjusting lower to potential technology regulation and higher interest rates. The commodity sector is responding positively to the reflation trade momentum and we show how rising inflation have historically been positive for the commodity sector.
While the Wall Street Journal is still calling the Ossoff (D) vs Perdue (R) Senate runoff seat too close to call, while the Warnock (D) won the other seat, others have already said that the lean in the still to count mail-in votes is typically in favour of Democrats and thus the Democrats have most likely got a sweep for a 50:50 tie in the Senate with Vice President elect Kamala Harris deciding in case of a tie. The market seems to agree with a Democratic sweep scenario pushing the US 10-year yield to 1.02%, the highest level since March 2020, as the market is pricing more stimulus this year to combat the economic fallout from the Covid-19 pandemic. More fiscal stimulus with the implicit goal of restoring the unemployment level to pre Covid-19 level will ensure strong demand in the economy and help underpin higher inflation rate.
Nasdaq 100 is more rate sensitive in the short-term
The market is also clearly pricing in a Democratic majority in technology stocks with the Nasdaq 100 futures down 2% as the “Blue wave” scenario opens up a path for more technology regulation, wealth tax, higher corporate tax rate, more subsidies to green energy technologies and more stimulus which could push rates higher and thus negatively impact rate sensitive assets such as growth stocks, SPACs and private equity. As we said on our morning Saxo Market Call podcast the 12,500 level is likely a psychologically important support level that if broken could trigger further selling in US technology stocks.
The interest rate sensitivity will suddenly with the US 10-year yield above 1% begin to be a topic discussed on Wall Street. Here is some simple math to understand the concept. Nasdaq 100 is currently valued at 3% free cash flow yield whereas the S&P 500 is valued at 4.1% free cash flow yield. The free cash flow yield on equities spread to the global corporate investment grade yield has been quite stable the past 2 years. Assuming same spread a 100 basis points move in the US 10-year yield and assuming unchanged free cash flow would lead to 25% decline in Nasdaq 100. As the S&P 500 has financials that benefit from rising interest rates the spread would likely only move 0.7%-point higher leading to a 15% decline in the S&P 500. Offsetting these declines is of course the relationship that rising rates come with higher growth and thus the decline is likely not as dramatic. Also, the Nasdaq 100 is growing free cash flow much faster than the S&P 500 which means the difference would be smaller than our simple case. But nevertheless, it shows how rate sensitivity works and why Nasdaq 100 is more sensitive in the short-term. The most sensitive segment is of course highly valued growth stocks with negative free cash flows.
Commodity sector does well under rising inflation rate
This Monday we presented our Saxo Commodity Sector basket highlighting 40 stocks that provide a broad exposure to the commodity sector across four industries such as agriculture, chemicals, energy, and metals & mining. The entire sector is part of the reflation trade that will undoubtedly get more fuel from the Democratic majority in the US Congress. With the NY Fed Underlying Inflation Gauge Index (measuring both offline and online prices), China PPI Index y/y, and ISM Manufacturing Prices Paid all pointing towards higher inflation this reflation theme can no longer be questioned. The chart below shows the Saxo Commodity Sector basket excess monthly return in % over MSCI World against monthly %-points changes in the NY Fed Underlying Inflation Gauge Index. While rising or falling inflation does not perfectly explain the variation in commodity sector excess return it does have some weak impact. When the monthly change in inflation rate is positive the average excess return is 3.1% and when the inflation rate is falling the excess return is 0.3%.
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