Heading into the second quarter, the US economy is rapidly strengthening with COVID-19 cases plummeting and vaccinations driving the US toward herd immunity. Further economic strength will come from the $1.9 trillion “CARES Act” – Corona Virus Aid, Relief, and Economic Security Act – and an anticipated $2 trillion infrastructure bill that will provide massive fiscal stimulus. With continued record monetary stimulus, global economic recovery is inevitable and significant capital market changes will occur. Bond yields will continue rising from their historically low levels to their pre-COVID yield levels. COVID-19 stock beneficiaries like “stay at home stocks” including FAANG stocks, large-cap tech, and growth stocks will underperform and “reopen stocks” like leisure, travel, hospitality, retailers, banking, commodity, and cyclical stocks will outperform with a sharp earnings rebound. Last week’s sharp rise in 10-year US Treasury bond yields resulted in a sharp pullback in tech stocks and the major averages.
This letter will explore the equity sector rotation and rising interest rate environment of the coming year and its profound investment consequences. This rotation and economic rebound will be a rare economic and investment phenomenon unlike any since the collapse of Bretton Woods and the oil embargo of the early 1970s.
Interest rates will rise to pre-COVID levels and this is being driven by the rapid decrease in COVID-19 cases and vaccine accelerated herd immunity in the US. Herd immunity should be achieved globally in 2022.
In the United States, COVID-19 cases were 312,097 on January 8th and declined to 72,565 cases on February 25, a 76.7% case decline. With the benefit of nearly 1 million immunizations a day, herd immunity looks to arrive in the second quarter of the year. With COVID-related lockdowns reversing, the seven million remaining COVID-19-unemployed job seekers should find reemployment as locked down businesses reopen. With the Federal Reserve targeting full employment and a new tolerance for inflation, interest rates should rise with increasing economic strength. With inflation (rising prices) already showing up in food, energy, and commodity prices, the question is: Will the forthcoming monetary and fiscal stimulus lead to an inflationary spiral and a consequential rise in interest rates like that experienced in the 1970s?
Below is a chart showing the yield for the 10-year US Treasury Note and in recent weeks it has been rising with increasing rapidity. Less than 3 years ago the yield was 3%, returning to those levels in the next 18 months seems quite reasonable. A 1.5% rise in 10-year US Treasury yields will negatively affect both stocks and bonds. Long-duration stocks such as growth stocks and utilities should underperform, and bonds will absolutely decline in a rising rate environment.
The 60-year chart below of 10-year US Treasury yields shows a dichotomy of rising rates and declining rates. The 1962 to 1981 period was a rising rate and inflationary environment when the 10-year US Treasury yield rose from 3.85% to 15.84%. The inflationary period of the 1970s was exacerbated by the oil embargo of 1973 and 1974 when oil prices spiked from $21/barrel to $126/barrel. The oil embargo spread inflationary costs throughout the economy and contributed to the historic 1973-1974 bear market on Wall Street. The second period from September 1981 to August 2020 was deflationary and it experienced a 40-year decline in 10-year US Treasury yields from 15.8% to 0.5%. This deflationary period benefited from globalization and transformative computer/internet technology developments that significantly reduced costs through enhanced productivity, resource management, and allocation.
While yields should logically return to pre-COVID levels, we are deeply concerned that rising commodity prices, excessive monetary stimulus, and the Federal Reserve’s new more inflation tolerant mandate could lead to significantly higher interest rates.
Equity Strategy – The Great Rotation:
The proper response to rising rates leads to one simple bond portfolio adjustment – reduce duration risk. The proper response to rising rates for equity investing is more complex. We are reducing growth and technology holdings and buying equity laggards which will have meaningful or predictable economic cyclicality. In the chart below, OPCO’s Ari Wald, CFA, CMT identifies financials, technology, consumer discretionary and industrial equities which are already benefitting from the economic recovery and are logical investment themes.
Below is a second chart by Ari Wald, CFA, CMT. It shows the value to growth equity dichotomy over the last 30 years. In particular, this chart shows the extreme overvaluation of growth stocks versus value stocks during the 2000 tech bubble period and then the subsequent rebound of value stocks from 2000 to 2008 when a commodity bull market emerged wreaking havoc on financial assets. We believe a similar hard asset-oriented environment is unfolding now and could potentially last for years.
Rising Rates and Market Valuations:
The Fed Model provides a valuation framework to quantitatively compare equity prices and bond prices – technically, the Fed Model compares the earnings yield of equities to the yield of the 10-year US Treasury Note. The single most compelling argument for equity valuations today is the Fed Model.
The table below shows critical moments in the market since February of 2020 before stocks collapsed during March 2020.
Below is a quantitative chart combination of the Federal Reserve Model aka Risk Premium Model that shows the S&P 500 earnings yield and compares it with the 10-year US Treasury yield. We have found great value in the trend in earnings yields and the trend in bond yields, far more than the static risk premium value itself. In the middle pane below, the earnings trend is shown by the red line. Currently, the S&P 500 blended earnings line is rising rapidly and approaching last year’s peak level of 166 hit last February. S&P 500 earnings estimates for 2022 are 195. During the next year, 10-year US Treasury yields should rise to the 2-3% level. The risk premium today is attractive measuring 3.08%; however, if 10-year US Treasury rates were to rise to 3%, the risk premium would drop 1.5% to 1.58% a far less attractive level than has been seen since the financial crisis. If the 10-year US Treasury yield were to rise to 4.5%, then the risk premium would decline towards zero – a level not seen since the 2000 tech bubble.
We expect interest rates to rise and earnings to rise over the next year; however, as last week’s rapid rise in the 10-year US Treasury yield to 1.61% illustrated, the stock market can quickly decline in a rising rate environment.
The Commodity Cycle:
One powerful market cycle we believe is unfolding is the commodity cycle. The commodity cycle occurs during inflationary environments and is correlated with rising interest rates. We believe one has begun and will only accelerate from here. These inflationary periods often happen in the aftermath of a stock market boom. These cycles are shown in the chart below. Inflationary periods started following bear markets in 1929, 1971, and 2000.
Gold and precious metals have been in a strong upward move since 2019. In the past year, copper, soybeans, lumber, and corn have been rising rapidly.
The chart below shows the ratio of the S&P 500 index to the Goldman Sachs Commodity index. When this line is rising, it typically reflects a commodity bull market. When it is declining, the market is in a deflationary environment. The chart suggests the commodity bear market bottomed in April 2020 when oil futures prices turned negative. The ratio appears to have turned up and is rising, potentially confirming a new commodity cycle and inflationary period.
Specific Investments Ideas:
While signs of speculation are rampant and many valuation measures show the stock market is in bubble territory, the Fed Model or Risk Premium Model shows the market can trade higher on rising earnings driven by the demise of COVID-19 and government stimulus. The stock market can continue to rise according to the Fed Model and 10-year US Treasury yields could rise from today’s 1.42% to 3% within a year and possibly 4.5% without undermining this bull market.
Our fear is that inflation is creeping back into the economy and 10-year US Treasury yields could rise beyond 4.5%. Should that happen, financial assets will decline and commodity cyclical investments should outperform.
Natural Gas – a Commodity:
Natural gas is the clean fossil fuel that has helped the US to become the world-leading energy exporter with low carbon emissions. We continue to own and like Antero Resources Corporation (AR) and Antero Midstream Corporation (AM) which have had blistering share price appreciation since last March. Their recent earnings report continued to be encouraging but, an unexpected 27% dividend cut from $1.23/share to $0.90/share announcement by AM, was momentarily disturbing. In the final analysis, the distribution cut will help the AM fund a new joint venture drilling partnership with QL Capital that will help it generate $450-500 million free cash flows over the next five years. These free cash flows will be used to retire debt and continue to buy back AM stock, and support a dividend yield of 9.7%.
The QL Capital drilling partnership will increase AR’s free cash flow by $400 million and lead to a total $1.5 billion in free cash flow forecast through 2025. AR’s market capitalization is $2.71 billion. AR owns 28% of AM and its AM shareholding is worth $1.17 billion.
We continue to see AR and AM as leveraged investments in natural gas, with sophisticated management, with considerable share ownership, and during a very constructive natural gas environment. AR is the second-largest LNG producer and third-largest natural producer in the United States.
A Renaissance in MLPs?
It has been a brutal seven years for the fossil fuel industry and MLPs have suffered ESG selling and disdain while green energy alternatives have been the hot area in energy. Today, MLPs’ operating models have evolved to be self-funding and cashflow generative. This means new projects are largely funded internally by MLP generated capital. This funding shift to financial independence is a significant change in the midstream energy infrastructure story from a few years ago. Today, MLPs are a thoughtful investment for income-seeking individuals.
We are buying four MLPs for our clients: Energy Transfer, LP (ET) – 7.5% yield, Enterprise Products Partners, LP (EPD) – 8.04% yield, MPLX, LP (MPLX) – 11% yield, and Magellan Midstream Partners, LP (MMP) – 9.56% yield. These four companies are an excellent hedge against inflation, a solid source of tax-advantaged income, economically cyclical, and compelling alternatives to bonds whose maturities exceed five years.
The chart below shows the yield spread of MLPs compared to the 10-year US Treasury yield. MLPs are currently trading 7.9% higher than the 10-year US Treasury and this spread normally trades slightly under a 5% premium. Historically, buying MLPs in the wake of a spike in this yield spread as we did in 2008, 2016, and 2020, has proven a successful strategy. Buying MLPs in an inflationary environment should provide outperformance while traditional income sources like utilities and bonds will likely decline.
Other Inflation Hedge Investments:
We are investing in cyclicals, industrials, mining, and banking stocks as well as commodities, precious metals while rising interest rates are expected. We are selling interest-rate sensitive securities such as bonds, utilities, growth stocks, large-cap tech and FAANG stocks which we believe will lose the leadership role that they have held over the last few years. FAANG stocks, in particular, are likely to come under increasing selling pressure as their first, second, and third-quarter earnings compare against last year’s tremendous COVID-19 enhanced quarterly earnings. This marked deceleration in earnings growth is deadly to growth stock valuations and we expect the FAANG stocks to weigh on the market. Further, increasing negative press on social media, lawsuits, and antitrust litigation will undoubtedly tarnish the FAANGs’ pristine images and drag on their operations in the coming quarters. This could lead to large price declines that typically occur following parabolic stock price moves or stock market bubbles.
There is a risk that inflation could spawn a market and economic environment reminiscent of the 1970s, which was a grim period for both equity, and bond investors. Among the rare winners in the 1970s were real estate, precious metals, and oil. By rotating towards a commodity cycle sensitive portfolio, we should be able to mitigate market risks that could be significant should inflation drive much higher interest rates in the years ahead.