Morning Notes — Tailwinds, Headwinds and Bond Yields

Bond yields: The recent consolidation in bond yields has been mostly driven by technical flows from private pension plans and some systematic funds. An estimated 97% of private pension plans have reached funded status, largely due to a strong equity market. Pension funds (private and public) had increased their allocation to equities in the post-financial crises environment as lower bond yields threatened their funding status.  Some of that began to unwind at the end of Q1 and expect private pensions will be a source of steady Treasury demand into heavy issuance. Rising expectations for a Q4 QE tapering on tightening labor market data is the catalyst to move yields higher.  Many systematic funds use momentum as a trigger and we’d expect increased near-term systematic fund (CTAs etc.) flows should 10-year yields dip below the 50-day moving average at 1.56%.  Ten-year yields were slightly below that level last week, but not below the 50-day average, which is rising.  Our short-term yield target of 1.45% (best-case scenario to add cyclical-value equity exposure) still seems possible, but a push through 1.64% would remove the target with a further upside to the next resistance level at ~1.90%.

SVX: Rising bond yields and the potential for higher corporate tax rates are not the best trends for the super-large cap growth/Tech stocks that comprise the Nasdaq 100 (NDX).  The top-5 holdings in the NDX by market cap are the same top-5 holding in the S&P 500 (SPX).  The NDX will struggle to move higher if 10-year yields release through 1.64% as we expect. In a steady-state macro environment, we’d still expect some upside in the NDX and the SPX, but both should materially underperform the S&P 500 Value Index (SVX).  Our preference to add equity exposure in cyclical/value sectors began in mid-September when real-yields bottomed.  We gained conviction on the November 9 vaccine data and will stay with it until global PMI data inflects lower, which seems highly unlikely over the next 2-3 quarters.

Tailwinds: Policy stimulus already in the pipeline is the single biggest tailwind for equities.  Other tailwinds include the positive macro backdrop, upside Q1 earnings results, renewed pickup in stock buybacks and an improving vaccination pace in Europe.  The EU is expected to have vaccinated 25% of the population by the end of April with the UK now above 60% and the US over 50%. The US looks to return to pre-pandemic consumption levels this quarter.  The US engine has started and the European engine will likely drive an acceleration in global growth beginning over the next month or two.  European consumption is currently running 7-8% below pre-pandemic levels, but should get there with double digit growth expected over the next few quarters.

Headwinds: Potential policy shifts are obvious headwinds with Democrats proposing higher corporate/personal tax rates and the Fed expected to taper QE later this year.  The Fed isn’t expected to change it’s language around QE when they meet this week, but is expected to signal a shift at the June meeting. Ten year yields, currently at 1.57% are inconsistent with an eventual tapering of Fed bond purchases.