That’s why equity investors shouldn’t be afraid of rising interest rates

Rising interest rates can set off alarms in the stock market, but strategists say you have to be prepared, not be afraid.

For now, interest rates are going up with the idea that inflation will also rise.

But the alert right now probably looks more like a smoke alarm and a burnt-out frying pan than a house on fire.

“It’s less about the absolute level of returns and more about how fast it takes to get there, and at this point we’re not concerned with speed,” said Julian Emanuel, chief equity and equity strategist. derivative products at BTIG.

The most closely watched yield is the 10-year benchmark treasury, which affects mortgages and other loans.

It was lower on Tuesday at 1.16%, after hitting the key level of 1.2% on Monday. At this level, strategists say it would head towards 1.25%, which could initiate another higher breakout. At the end of January, the yield, which moves opposite the price, hit a low of 1%.

Bond pros say yields are rising and rising for several reasons.

One big factor is Covid’s fiscal stimulus, the $ 900 billion approved in December, and the $ 1.9 trillion plan that is currently making its way through Congress.

Better growth is expected with federal money, but this also translates into increased debt and potentially inflation. This is another reason for higher returns.

BTIG’s Emanuel said he would be concerned if the 10-year yield started to rise. He expects it to hit 1.7% by the end of the year.

However, if it moved too quickly, stocks could find themselves in a tough spot. For example, a danger zone would be around 1.34% if the 10-year yield hit that level as early as this month.

“This would likely be a stock that caps the upside in the markets and causes further rotation from high growth multiple stocks to cyclicals and value,” Emanuel said.

“Cyclicals, in particular, could absorb this kind of rotation and keep the market moving,” he added. “The same speculative interest that the public has shown in tech stocks … it’s entirely possible that at some point in 2021, you could feel a degree of speculative fervor that you’ve seen in these guys, by going towards financials. “

The S&P financial sector is up around 6% year-to-date.

Banks rose as the yield curve steepened. It just means that the difference between short-term rates, like 2-year rates, and long-term rates, like 10-year rates, has increased.

This so-called steeper curve helps banks make money because they can borrow at very low short-term rates and lend at a higher rate for longer periods.

Bank of America strategists say energy and tech hardware are among the expensive sectors that could be hit by the rate hike. Banks, diversified financial services and semiconductors are among the cheap sectors benefiting from the rate hike, they added.

But strategists say Treasury yields, while rising, are far from competing with stocks for investment dollars.

Lori Calvasina, head of US equity strategy at RBC, said there was no 10-year fixed level that would be a negative trigger for stocks, but “3% feel like it’s there that people tended to worry about in the past. “

Calvasina said she is monitoring the number of S&P 500 companies paying dividends above the 10-year yield. At the start of the year, 63% of S&P 500 companies had dividends above the 10-year yield, and several weeks later it was 56%.

“If it drops to 20% or 30%, at that level, the market might start to struggle,” she said. If the market is not having problems at this point, there are still problems and investors see less return over time.

The rise in inflation rates and trade is largely the cyclical rotation in value that began in the second half of last year, as vaccine news was positive and investors began to hope for a more normal economy in 2021.

Inflation expectations have increased but are still low.

The 10-year breakeven point, which is a measure of market-based inflation, stood at 2.20% on Tuesday, down from around 2.1% at the start of last week. This means that investors are betting that inflation will average 2.2% over the next 10 years.

RBC’s Calvasina said that as rates rise and inflation expectations rise, investors should stick to reflation.

Reflation trading is when investors bet on companies that will be successful when the economy improves and reopens. This includes airlines, financials and manufacturers.

Calvasina has also said she loves the financial industry, but some investors mistakenly believe that parts of the reflation trade are already done.

Energy could rise by more than 15% with the rise in oil prices this year, but other cyclical sectors, like materials and industrials, are up about 2% since the start of 2021.

The growth areas in technology and communications services could be used as a source of funding for the rotation, as they have performed well, Calvasina said.

“As inflation expectations rise, you tend to see technology underperforming, communications services underperforming. The parts that tend to do well are commodities and financials.” , she added.

Jonathan Golub, chief US equity strategist at Credit Suisse, says he doesn’t expect technology to be too affected by the rate hike. But the stocks to buy in this environment are among the most “junki”.

“I don’t think technology is going to choke. I think the best way to look at it is to find out who earns the most from an improving economy. The answer is cyclical businesses … and businesses that have a business problem, ”he said. . “You want someone who’s on the brink, a smaller cap, companies with a lot of debt.”

Golub also said the rise in Treasury yields is also positive for the market as it represents an improving economy.

“The most stimulating event in the history of the planet will not be the end of the First World War, the end of the Second World War, it will be the reopening of the economy this summer”, he said. declared.