Any risk-averse investor who has hunkered down with stable, dividend-spinning stocks must be wondering what upside-down world they’re living in: Safe investments are being clobbered – again − as bond yields rise to multiyear highs.
Market activity on Tuesday underscored the trend. The S&P 500 fell 18.68 points, or 0.7 per cent, retreating from a two-month high and breaking a four-day winning streak.
Were investors running from economically sensitive stocks and into the sort of companies that can thrive during periods of uncertainty?
Uh, no: U.S. financials fell just 0.2 per cent while traditionally safe high-yielding utilities and real estate investment trusts fell 0.9 per cent and 1.7 per cent, respectively.
The divergence follows substantial moves in Canadian and U.S. government bond yields, which are anticipating additional interest-rate hikes by central banks.
The yield on the 10-year Government of Canada bond rose to 2.49 per cent on Tuesday, which is its highest level in about four years. The yield was just 1.4 per cent a little less than one year ago. As yields rise, bond prices fall.
The yield on the 10-year U.S. Treasury bond, which rose above 3 per cent in late April, is now 3.07 per cent – its highest level in nearly seven years and up from about 2 per cent in September.
Tuesday’s gain of nearly seven basis points (there are 100 basis points in a percentage point) is the biggest increase in yield since February and follows an encouraging report on U.S. retail sales in April.
“Consumption growth is on track for a big rebound in the second quarter, which should push overall GDP [gross domestic product] growth up to more than 3 per cent annualized,” Michael Pearce, an economist at Capital Economics, said in a note.
He added: “That will keep the Fed on track to raise rates again at its June meeting.”
What’s more, Bloomberg News pointed out that financial markets now believe there is more than a 50-per-cent chance of three additional U.S. rate hikes this year – for a total of four hikes in 2018 – which is more than what the Federal Reserve has projected.
The stock market is digesting the implications of tighter monetary policy and higher bond yields. And over all, traditional safe stocks that generate steady dividends and profit, but show little growth, have been clear laggards.
That’s because these stocks look relatively less attractive next to higher-yielding bonds. At the same time, financial stocks tend to do well in a rising-rate environment when the economy is sound, because bank loans are more profitable and the extensive bond portfolios held by insurance companies generate more income.
Within the S&P 500, financial stocks have rallied about 19 per cent over the past year, while big-yielding utilities have retreated more than 4 per cent. Within the S&P/TSX composite index over the same one-year period, a similar trend has unfolded: Financials are up nearly 8 per cent and utilities are down more than 10 per cent.
Savita Subramanian, the equity and quant strategist at Bank of America Merrill Lynch, noted on Monday that investors have been making a mistake for the better part of a decade in determining what is a safe stock.
“Market participants have been mispricing risk since the financial crisis, in our view, conflating safety with low price volatility, and capital preservation with high dividend yields,” Ms. Subramanian said.
It isn’t working. Instead, she argued that growth stocks with high expectations for profit growth over the next five years are poised to deliver the biggest gains, given that these stocks trade at the deepest discount relative to book value since 2001.
If she’s right, investors who continue to seek the safety of dividends could have a rough year.