Morning Notes — Underlying Strength in Cyclical/Value Sectors

Real yields are higher this morning after Powell’s press conference takeaways pull taper announcement expectations slightly forward, while holding rate hike expectations in check (“absolutely no sense of panic” about inflation). The relative performance of small cap stocks and cyclical/value sectors have a high positive correlation with real 10-year Treasury yields. The Russell 2000 (RTY) and S&P 500 Value Index (SVX) are outperforming this morning as a result. Real yields have retraced back to September/October levels over the past two months, but the fundamental and technical backdrop have us expecting higher levels from here. Higher real yields generally create a headwind for high multiple stocks with the breaching of technical thresholds leading to accelerated sector rotation.  There also happens to be a strong negative correlation between real yields and the price of gold.  

Unintended: Our preferred cyclical/value sectors are Financials, Materials and Industrials. Energy is the cheapest of the value sectors and hard to love on the surface, but there might be more to the story.  It’s easy to dismiss currently higher crude prices based on transitory inflation arguments and secular demand concerns given decarbonization efforts.  However, government-led decarbonization efforts may actually create sustainably higher oil prices by reducing investment capital for new production capacity, while a transition to renewable energy demand could take decades.  You can see the reduction in capital investment playing out in CQ2 earnings reports with oil companies choosing to reduce debt and increase dividends, while reducing capex for new capacity.