The much-publicized market trends continue to be reinforced. Since the yield on the 10-year Treasury bottomed out in August of last year at around 0.51%, that yield has now more than tripled to over 1.6%. The increase in interest rates has corresponded to the continued outperformance of value stocks relative to growth stocks. In the chart below, we show that the Russell 1000 Value index has outperformed the Russell 1000 Growth index by over 14% since interest rates bottomed. Lest anyone think that trend reversal has come too far too fast, we should remember that in the 10 years leading up to the trough in interest rates last year, the Russell 1000 Growth index produced an annualized total return (including dividends) of 17.2% compared to just 10.0% for the Russell 1000 Value index. On an unannualized basis, the Russell 1000 Growth’s total return was +388% over that 10 years compared to just +158% for the Russell 1000 Value index. For anyone who believes in mean reversion, we could have a long way to go.
Almost nobody believes that interest rates will climb too much farther from here. The most aggressive forecasts I’ve heard call for the 10-year Treasury yield to climb to just 2.0% by the end of the year. The interest-rate increases, they say, will be capped by the Fed’s willingness to increase its bond purchases if and when the need arises. But it’s not a foregone conclusion that the Fed will be able to maintain control of longer-term interest rates. The bond market is telling us that investors are nervous about the possibility of spikes in inflation later this year as the economy reopens. And though recent inflation indicators suggest price increases remain fairly modest, the trend is clearly higher. The Fed, for its part, continues to pound the narrative that the increases in inflation later this year should be temporary. Any spikes in inflation we do see, the Fed says, will simply be a one-time adjustment due more to base effects than anything else. Is it possible they’re wrong? And if so, what then?
There is a lot of stimulus hitting the economy at the same time that vaccinations are expected to end the COVID scourge. The $900 billion passed by Congress in December has yet to be fully spent, and we just added another $1.9 trillion. We’re now hearing that an infrastructure bill later this year, which Democrats hope to pass through reconciliation requiring only a majority vote, could be as large as $3 trillion. There is simply no way that fiscal stimulus this immense, which combined would amount to over a quarter of our GDP, will not lead to a scenario whereby demand outstrips supply. If we add the further pressures of disrupted supply chains and trade disputes, the impact on prices could be dramatic. I, for one, am not expecting that the Fed will be able to sit on its hands throughout this process. I think they will have to step in to arrest the spikes in inflation that are looking increasingly likely. And so interest rates are heading higher, and where they stop, nobody knows.
The reduced allure of high-growth and expensive mega-cap technology stocks is rational based on the interest-rate backdrop. Unless something changes fairly dramatically, I’d expect investors to continue to favor high-quality and more reasonably valued stocks that will benefit more fully from the economy’s reopening and can better withstand the rise in interest rates. The playbook of the last 10 years is unlikely to work anymore.