The “real” story behind the fall in 10-year Treasury yields and the S&P 500
The 10-year Treasury yield closed at 1.18% yesterday, its latest stop on a three-month decline that has returned it to February 2021 levels, before COVID-19 vaccines became broadly available. The S&P 500 is up 8.5% since February, but was down 1.6% on Monday. After weeks of disconnect from falling yields, the equity markets are finally sniffing out that growth is peaking.
Indeed, the nominal 10-year rates are falling primarily because of the fall in real rates (which have declined 35 bps since June 16) while inflation breakevens remain anchored around 2.3%. This suggests that the threat of the Delta variant and slow progress on infrastructure stimulus is dragging down consensus growth expectations and putting downward pressure on yields.
The combination of slower growth and sticky inflation poses a potential threat to corporate margins. This is one of the reasons why the markets are not reacting favorably to the so-far stellar Q2 earnings – with 8% of the S&P 500 reporting, 85% of companies are beating earnings estimates and the average surprise is 22.9% above estimates.
The other reason why we view yesterday’s pullback as unsurprising is because of the exuberance in investor positioning. Over $500 billion flowed into global equities this year. And hedge fund positioning was near recent net-long records (93rd percentile net long in the past three years). Not surprisingly, given the catalyst of slower growth expectations, the markets were susceptible to a pullback.
We still believe that equities will finish higher by year-end because, despite the Delta variant concerns, levels of vaccinations and natural immunity are much higher than they were in February (when the 10-year yield was at the same level as today). However, we would like to see positioning unwind a little further before sounding the all clear and recommending investors aggressively buy the broad market. Until then, selective buying in financials and semiconductors may make sense. Within hedge funds, here is what we are watching in the meantime.
How hedge funds are adjusting after a year of near-record net longs
Hedge funds – which had their best H1 since 1999 by increasing net longs – are adjusting quickly and are partially behind the recent market moves. Last week, hedge funds were net sellers of Info Tech. Global sector flows indicate the largest weekly dollar net selling in more than five years.1
Hedge funds have also been noticeably increasing their single stock shorts in 8 out of 11 sectors. This activity indicates that hedge funds are preparing for a market that may be more narrow, with more return dispersion between stocks and sectors, and lower intra-stock correlations compared to the broad, low return dispersion and high correlation market of the first half of 2021.
Three trends to watch in hedge fund positioning in the coming weeks
1) Hedge funds could further reduce tech, especially software, pressuring valuations
The S&P 500 Software index is trading at a 10-year high price-to-sales multiple of 12.68x, almost two points higher than in May, as the index rallied +16.5% since then. In the meantime, the hedge funds’ long/short ratio for software is near recent highs as well and hedge funds’ overweight to software versus the S&P 500 is +8% , suggesting there is room to reduce exposure. Given that the sector recently hit the technically overbought level, further near-term reductions are likely.
2) Hedge funds may pare back the cyclicals trade and industrials could be at risk of a deeper pullback
Hedge funds increased their bullish bets on cyclicals this year bringing their weighting almost in line with the S&P 500, from a 4% underweight in early 2020. However, with global manufacturing PMIs tentatively peaking and the U.S. infrastructure stimulus still not done, cyclical longs like industrials may be at particular risk of being unwound. The industrials sector is trading at 24.5x next 12-months P/E versus 22.4x for the S&P 500 and above its own 10-year average.
Should the infrastructure deal, which was expected to prolong the industrial recovery, be much further delayed or scaled down, the premium valuations for industrials may not be justified. This will be especially true if manufacturing new orders growth slows – we’ll see what happens in a report expected later this week.
3) Hedge funds could begin to add to China tech, helping the sector find a floor
While hedge funds are long U.S. tech, they have meaningfully reduced their China exposure and are now the least overweight since June 2019. China tech fell sharply and is down 16% from its recent peak in mid-February, while U.S. tech rallied 9% since then. As a result, China tech is trading at 24.4x forward P/E, just below the U.S. tech multiple of 24.7x and cheaper than its five-year average ratio of 1.3x.
Analysts are also starting to suggest that China regulatory risks are increasingly priced in given this underperformance. Meanwhile, China’s macroeconomic policy is turning incrementally more balanced – last week’s reserve ratio requirement cut for banks is meant to cushion growth as it comes off the post-pandemic rebound.
The Bottom Line
Given hedge funds’ overall elevated equity positioning and the rotations that are likely needed to position for less growth, more inflation, and more uncertainty ahead, we could see more downside in software and select cyclicals like industrials in the days ahead. On the bright side, earnings season is a good time to be a stock picker. With earnings season heating up this week and next (17% of S&P 500 companies report this week and 42% report next week ), the average performance dispersion between stocks should widen and fundamental long and short stock selection could pay off. And while we can’t recommend specific stocks to buy and sell, this earnings season I’d be long real estate (lowest consensus return expectations), short used cars (unsustainable price appreciation), and adding to financials on weakness (preferred reflation continuation trade).
(1) Source: Goldman Sachs Prime Service Weekly Report – July 16, 2021.
(2) Source: Bloomberg, as of July 19, 2021.
(3) Source: Goldman Sachs, Prime Insights & Analysts Monthly, July 14, 2021.
(4) Source: Goldman Sachs, July 16, 2021.
(5) Source: Goldman Sachs, Prime Insights & Analysts Monthly, July 14, 2021.
(6) Source: Bloomberg, as of July 17, 2021. China Tech is represented by MSCI China Information Technology index and U.S. tech by S&P500 Information Technology index.
(7) Source: BofA Global Research, July 19, 2021.
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