How worrying is the latest move up in bond yields?
Reflation was never a reason to be bearish on equities
* There were good arguments for volatility to increase in the short term –
elevated P/Es, strong prior run, position squaring in crowded trades, bad
seasonals etc – but the spike in bond yields should not be added to this list,
in our view. In fact, we think that the move up in bond yields is one of a range
of factors signaling that the next stage for the market will be the reflation
trade, and that the risk-off phase will not last beyond a few weeks:
* 1) Yields moving higher will end up an eventual positive. We note that in ‘13
the bond selloff drove a correction initially, only to be followed by a strong 2H
equity rally, where SPX moved up by 15%, despite 10 year yields selling off
150bp.
* Banks are helped when yields increase. There is a strong positive relationship
between the relative performance of BKX index and the 10 year yields, as per
top chart. The relative performances of Cyclical vs Defensive sectors and of
Value vs Growth styles are also linked to the bond yield direction. We note that
since the peak of SXXP on 27th April, the Defensive group has in fact
underperformed Cyclicals by 20bp, in the down market. We stay UW Utilities in
particular and stay OW Banks, even during the correction phase.
* 2) DXY rolling over is reflationary, as it underpins commodity prices. The
correlation between oil price and the equity markets, or indeed the oil and
earnings, remains resolutely positive. Stay OW Energy.
* 3) Inflation expectations are rising, reaching their highest level since last
November. This is in stark contrast to Q4 of last year when the collapse in
inflation expectations was pressuring equities, and Banks in particular.
* 4) M1 keeps moving up in Eurozone. This suggests there are further gains in
Eurozone PMIs in store for 2H. The peripheral PMIs in particular are breaking
out.
* 5) Credit is turning higher. Loan growth is bottoming out in Eurozone. Cost of
credit is coming down.
* May remains seasonally a poor time for risk trades, but we believe that, beyond
some potential further short-term position unwinding, the backdrop for the 2nd
half is looking increasingly encouraging. The signs of reflationary dynamics
taking hold should lead to the next leg higher in equities, driven by Banks,
commodities and Cyclicals. Among our key sector calls we are OW Banks and
OW Energy vs underweight Utilities and Staples, and are OW Cyclicals vs
Defensives.